Financial Reporting Concepts

Transcription

1 CHAPTER 1 Financial Reporting Concepts Chapter Contents 1.01 Objectives of Law Firm Financial Statements 1.02 Basic Financial Statements 1.03 Partnership vs. Professional Corporation 1.04 Accrual Basis vs. Cash Basis 1.05 External vs. Internal Reports 1.06 Net Income vs. Distributable Income 1.01 Objectives of Law Firm Financial Statements The primary objective of law firm financial reporting is to measure the amount of income (or loss) available to distribute to the partners and to communicate information useful to management, partners and creditors, that can be used to make business decisions. Law firm financial statements are management s representation of the firm s financial position at a particular point in time and its results of operations and cash flows for a particular period of time. Most of the information in law firm financial statements is taken from the firm s accounting records, which are organized like the components of the firm s financial statements (assets, liabilities, revenues and expenses). Information in the firm s accounting records is data accumulated through a series of processes representing the firm s accounting systems, which may be automated or manual. 1-1

2 1.01 LAW FIRM ACCOUNTING/MANAGEMENT 1-2 The form and content of law firm financial statements are not static. Financial statements are dynamic and can be affected by the environment and by limitations on the kind of information that periodic financial reporting can provide. For example, available financial information often results from approximations, rather than exact measures, and largely reflects the financial effects of past transactions, rather than present or prospective activities. The primary focus of readers of law firm financial statements is on information about the firm s earnings and partners capital. Information about cash flow and operational performance also receive considerable attention.

3 1-3 FINANCIAL REPORTING CONCEPTS Basic Financial Statements For a law firm, as with any other business, there are three basic financial statements that serve as a focal point for all financial reporting. These are the statement of net assets (also referred to as the balance sheet), the statement of revenues and expenses (also referred to as the statement of income) and the statement of cash flows. These statements are based on the following equations: Net Assets Equation ASSETS minus LIABILITIES = NET ASSETS Revenues and Expenses Equation REVENUE minus EXPENSES = NET INCOME Cash Flows Equation CASH FLOWS FROM OPERATING ACTIVITIES plus CASH FLOWS FROM INVESTING ACTIVITIES plus CASH FLOWS FROM FINANCING ACTIVITIES = NET INCREASE or DECREASE IN CASH AND CASH EQUIVALENTS While the form and content of individual financial statements are subject to wide variation, the rationale that underlies their structure is governed by the preceding fundamental equations. In deciding upon a particular manner in which to present financial statements, management typically selects an approach from a variety of acceptable accounting practices. Selecting the appropriate accounting practice will often depend on the facts and circumstances surrounding transactions and the best manner in which to communicate the financial effect of those transactions. Factors influencing the way financial statements are presented include the nature of the entity (e.g., partnership vs. professional corporation), the desired basis of presentation (e.g., accrual basis vs. cash basis), the intended primary audience for the statements (e.g., external vs. internal reports) and the purpose of the statements (e.g., determining net income vs. partners distributable income).

4 1.03 LAW FIRM ACCOUNTING/MANAGEMENT Partnership vs. Professional Corporation The majority of law firms are organized as partnerships. However, some firms have chosen to operate as professional corporations. The form of entity chosen by the firm will influence the form of presentation of certain economic activities in its financial statements, including owners equity, owners earnings and owners income tax, as summarized in the following table: Form of Presentation Owners equity: Partnership Statements Partners capital account Partners current account Professional Corporation Statements Common stock and paidin capital Retained earnings Owners earnings: Partners share of income Compensation of members Dividend distributions Owners income tax: Taxes are not recorded at the firm level; Partners are taxed individually on the distributions received from the partnership Firm s income tax provision on corporation s earnings Other than the inclusion of an income tax provision in the financial statements of a professional corporation and the resulting effect on the firm s earnings, the financial statements of a professional corporation differ from those of a partnership primarily in the form of presentation and not in economic substance.

5 1-5 FINANCIAL REPORTING CONCEPTS Accrual Basis vs. Cash Basis Law firms typically maintain their accounting records on the cash basis or modified cash basis (sometimes referred to as modified accrual basis) of accounting. Because they are relatively simple methods, they are less burdensome than the accrual method and they put aside the difficult issue of presenting the billable value and eventual collectibility of unbilled professional time in the financial statements. In addition, most firms also prepare their financial statements on the cash basis or modified cash basis because of their similarity to taxbased statements. However, a few firms, for various reasons, prepare their financial statements on the accrual basis because it presents a more realistic (and economic) picture of the firm for the reporting period. Generally accepted accounting principles (GAAP) are predicated on the accrual basis of accounting. Accrual accounting recognizes revenue and the related assets when earned rather than when received and recognizes expenses when the obligation is incurred rather than when paid. Financial statements prepared in conformity with GAAP are presumed to provide a better reflection of the firm s economic status than financial statements that are prepared on other bases of accounting. Generally accepted accounting principles represent the conventions, rules and procedures that define accepted accounting practice at a particular time and include, not only broad guidelines, but also detailed practices and procedures. Cash basis accounting recognizes revenue when the cash is received and recognizes expenses when the cash is paid. While the cash receipts and disbursements basis of accounting is recognized as a comprehensive basis of accounting other than GAAP, financial statements prepared on this basis are not presented, nor are they intended to be presented, in conformity with generally accepted accounting principles. The modified cash basis of accounting used by most law firms is a hybrid of the cash and accrual basis methods. Under this method, certain modifications are made to the cash basis accounts to overcome some of the distortive effects of pure cash basis accounting. These modifications generally incorporate some accrual basis concepts, such as recording client disbursements receivable, capitalizing and depreciating property and equipment and recording loans payable. The modifications usually are geared toward achieving symmetry between the basis of accounting that the firm uses for financial reporting purposes and the basis of accounting that the firm expects to use when filing its income tax return.

6 1.04 LAW FIRM ACCOUNTING/MANAGEMENT 1-6 The method of accounting chosen by the firm will impact the presentation of certain economic resources in the firm s financial statements, including uncollected billed fees, estimated value of unbilled time, accounts payable and accrued expenses, as summarized in the following table: Economic resources found in Assets: Accrual Basis Statements Cash Client disbursements receivable Billed fees receivable Estimated value of unbilled time Property and equipment Modified Cash Basis Statements Cash Client disbursements receivable n/a n/a Property and equipment Liabilities: Accounts payable and accrued expenses Benefit plan liabilities Loans payable n/a n/a Loans payable Some firms maintain their accounting records and prepare their financial statements on the modified cash basis of accounting and maintain additional memorandum records. These records identify the partners interests in memorandum accounts which, for the most part, represent the value of billed fees receivable and the estimated value of unbilled time, reduced by an estimate of fees that will become uncollectible and, in some cases, by unpaid accounts payable and accrued expenses.

7 1-7 FINANCIAL REPORTING CONCEPTS External vs. Internal Reports In recent years, law firms have responded to increasing requests for financial reports from outsiders (such as banks, former partners and debt holders, if any), and insiders (such as managing committees). These financial reports often include historical financial statements as well as communications regarding prospective financial information, such as management s budgets and financial forecasts. The financial statements and other financial information contained in financial reports furnished to these interested groups have usually been tailored to the needs of the users. The potential audiences need-to-know can often dramatically impact the form and content of the financial report, as reflected in the following summary of characteristics found in external and internal law firm reports: Characteristics of External Financial Reports Internal Financial Reports Accounting Method: Modified cash basis Accrual basis Focus: Net income Partners distributable income Frequency: Annual/quarterly Weekly/monthly Content: Basic financial statements including the related footnotes Income statement and operating statistics Time Frame: Historical Prospective and retrospective Corroboration: Audited Not audited External financial statements of law firms, particularly the larger ones, are often audited by independent accountants to enhance confidence in their reliability. Internal financial reports of law firms typically are focused on both historical and prospective events through comparisons to budgets or forecasts. These reports often contain key operating statistics, such as average chargeable hours, billing realization percentages and similar data.

8 1.06 LAW FIRM ACCOUNTING/MANAGEMENT Net Income vs. Distributable Income The bottom line or focal point of a law firm s financial statements is most often the firm s net income for the year. For external reporting purposes, the excess of revenues over expenses, which is often referred to as cash or modified cash basis net income, is the figure focused on because it represents the results of the firm s operations. For internal reporting purposes, the partners in most law firms are more interested in how much of this net income is available for distribution to the active partners. The key difference between net income and distributable income is payments to former partners. Typically, these payments are fixed amounts (stated in dollars or percentages), as laid out by the firm s general partnership agreement or arising from contracts with individual former partners. Former partners include partners who have retired or withdrawn from the firm and the estates of deceased partners. These payments represent the former partners share of the firm s net income recorded subsequent to the termination date and are frequently limited in the aggregate to a set percentage or portion of the firm s net income. These payments may be nominal or very significant. Generally, payments are exclusive of repayments of the partners contributed capital. When the amounts of payments to former partners are significant or are based on net income and the firm wishes to bridge the gap between external financial reporting focus and internal financial reporting focus, the firm may choose to present net income, payments to the former partners and partners distributable income in its financial statements. When such payments are not based on the firm s net income, they normally are reported as an expense when determining net income.