Thursday, August 07, 2008

Credits Calling from the Abyss

It is amazing that the life blood of modern day commerce rests on a system devised over 500 years ago. In 1494, Luca Pacioli documented the technique of double-entry bookkeeping, and from then became know as the ‘Father of Accounting’. One could only speculate that his reasoning for this technique was to accurately reflect the transactions of a business at any point in time. Over the years the complexity in commerce imposed tremendous challenges to double-entry bookkeeping; however the Pacioli model remained steadfast through generations.

Today’s methods of recording transactions are tremendously more complex than that practiced in the early 1500’s. However, accounting bodies all over the world actively postulate the best and fairest means by which to record complex transactions. With the rapid globalization of commerce, the International Accounting Standards Board works tirelessly to instill some order in complex global transactions.

Interestingly enough the bulk of the accounting problems faced by today’s organizations are not rooted in complex transactions, but rather the most rudimentary type of transactions. Over the past month, many organizations shared some of the difficulties facing their accounting departments. The two most prevalent difficulties were billing and cash receipts. Although both of these transactions seem so very simple; today’s business has created a wealth of unnecessary complexity from simplicity.

Payments come into all organizations by way of some type of negotiable instrument. For the most part, the person empowered to deal with these payments have been trained to know what to do. Often this training is ‘hand-me-down’ knowledge and is therefore often diluted. Very simply the negotiable instrument should be placed into the bank and the payment recorded in the organization’s financial records. However, I have seen organizations hold onto payments until they can ‘figure out’ how to treat them for accounting purposes; sometimes days if not weeks. Somehow organizations don’t realize that securing the payments and recording the receipt of funds are two very separate functions. The banking of negotiable instruments is a treasury function and is of paramount importance. The second most important activity is properly recording the receipt of funds. It is in the recording of these payments that organizations have conjured up a huge amount of complexity.

The best clarifying agent for the recording of cash receipts comes directly from accounting principles, known as GAAP. The one differentiating factor in dealing with incoming cash receipts is to determined if: a) revenue is earned and therefore payment due, b) or revenue is not earned and payment is not due. If the customer has remitted payment for goods or services rendered, revenue was earned and therefore the payment is due. Therefore recording of the receipt of funds becomes very simple; relieve the customer’s outstanding debt in the organization’s ledger. Even something this simple causes organizations anxiety. A moment spent examining the customer’s payment should provide insight to what bill they are paying. If this information is not readily apparent, it is the responsibility of accounting team to make contact with the customer to get the correct information. This simple customer exercise ensures that both the client’s records and the organization’s records properly reflect the transaction.

The receipt of payment when revenue is not earned and payment is not due, is experienced by many organizations in many different markets. In this situation, the customer is advancing payment for a specific purpose, often to be in compliance with the terms of engagement. Depending on the type of organization these funds could bring with them a whole host of special rules. In manufacturing or construction, these funds could be a deposit on an upcoming invoice. Therefore in the financial systems for these types of organizations there would be a method to reflect the receipt of these funds as a credit on the customer’s account.

In more service type establishments such as the practice of law, land title agencies, or real estate organizations there are specific rules as to the treatment of non-earned customer receipts. Each of these types of organizations must follow protocols as determined by their governing body. Often these rules differ by local jurisdictions and definitely by country. In my career I have had the greatest exposure to the cash receipts rules of legal practices. From my experience, commonwealth countries have the strictest rules by which client monies must be managed. In these countries essentially all non-earned cash receipts must be segregated from the firm’s operating funds accounting and a sub-ledger for each client must be maintained; in exceptional detail.

Law firms’ cash receipts can be sifted down to three main three types: a) payment for outstanding bills, b) payment for disbursement on a transaction, and c) payment as a retainer to an engagement. Very simply, the payments received are either in consideration of a bill or are not. Funds received as part of transaction type b or c create a tremendous amount of frustrations for most US firms simply because they are not related to a bill.

The treatment of unearned payments (b & c) is really very simple. The American Bar Association (ABA) has dedicated an entire section of their website to addressing these types of payments The site also provides links to local state bar association statutes and even foreign statues for dealing with these types of transactions. In addition to the ABA’s treatment there is an excellent book that adds clarity to managing law firm cash receipts: Accounting in a Law Office by Kenneth Laundy. In his book, Laundy demystifies all of the theories between earned and not earned cash receipts and their related treatment to remain in compliance with statutes. Firms must understand that unearned funds are NOT the property of the firm. Therefore they must be segregated from the firm’s operating funds and managed through the firm’s billing system sub-ledgers, by client. With that said a retainer is not earned revenue until billable hours or disbursements are added to the client’s ledger and a bill is produced. Equally, just as receipts as part of a settlement to litigation are NOT the property of the firm and therefore must NOT be comingled with the firm’s funds.

Cash receipts are the most fundamental part of any business. Their management should be as easy as Pacioli documented in 1494, they shouldn’t get lost in the abyss of complexities. There are governing bodies abound that provide direction for record keeping. So, simply deposit the instrument into a bank, properly record the transaction in the financial ledgers and… move on!

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