For years, Congress considered forcing law firms and other personal services providers with annual revenues in excess of $10 million to adopt the accrual method of accounting. The idea was pushed numerous times before Donald Trump became president with little success, only to be entertained as part of the Tax Cuts and Jobs Act of 2017. Fortunately, the provision never made it into the final bill.
That is good news for law firms. Why? Simply put, accrual accounting is bad for law firms. There is a reason nearly every law firm in the country prefers the cash method of accounting, a method that accounts for receipts and disbursements as they actually take place.
Defeating the provision was a victory for law firms when the 2017 tax bill was passed. But that's not to say Congress will not try to revive the idea at some point in the future. The legal and accounting industries need to stay on their toes, just in case.
Here are three reasons the accrual accounting method is bad for law firms:
1. It Makes Things Unnecessarily Complicated
The accrual method of accounting requires reporting income and disbursements at the time of billing rather than receipt. Subjecting a law firm's accounting to the accrual method creates all kinds of complications that are completely unnecessary.
For example, billing a client near the end of the fiscal year is not a problem under the cash method because income doesn't have to be accounted for until the bill is paid. Under the accrual method though, that income has to be reported based on the billing date. So even if the client doesn't pay until the following fiscal year, the money is still reported in the billing year.
Law firms are especially subject to all sorts of phantom income due to how they handle billing. Cash accounting deals with that phantom income without issue. Accrual accounting would only create unnecessary problems.
2. It Creates a Financial Hardship
Subjecting a law firm's accounting to the accrual method also creates a financial hardship. It forces firms to pay taxes on money it has not yet received. This may seem inconsequential to legislators who do not normally have to worry about their own cash flow, but it is a big deal for law firms.
The Gurian CPA Firm, a Dallas CPA and tax services provider, explains that law firms do not necessarily get paid on a set schedule. Moreover, they often have to spend a tremendous amount of money to litigate cases knowing full well that they may not get paid for quite some time. Expecting them to pay taxes on income not yet received is just not reasonable.
3. It Interferes with Service Delivery
Finally, mandating the accrual method of accounting would force law firms to insist on being paid up front. This could harm the attorney-client relationship by putting financial matters at the forefront rather than the case at hand. It would also hamper the ability of some firms to offer reduced-fee services to lower income clients.
All of this combined would reduce access to legal services among certain segments of the population. Law firms would be forced to give preference to wealthier clients capable of paying up front.
For now, the legal industry has been spared the burden of mandated accrual accounting. Likewise, other service-oriented businesses can continue using the cash method of accounting. Let's hope Congress doesn't backtrack and try to insert the mandate into future legislation. If they do, lawyers and their accountants will have to be ready to stand up and fight.