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Accountants, like most service professionals such as architects, attorneys, physicians, and therapists, earn revenue primarily based on hourly fees. Accounting firms engaged in fee-based financial planning or commission-based financial planning do not fit the hourly fee structure. Nevertheless, FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, applies to such revenues. Once the personal financial plan is rendered, the CPA has earned his or her flat fee or, once the client has purchased the recommended product, the CPA has earned the commission.
Revenue is recognized for the service as rendered. An audit client, for example, may pre-pay a portion or all of the estimated fee set forth in the engagement letter. This fee, however, is unearned (deferred) revenue until it is earned by billings against the fee received as the audit is performed. The basis for this treatment is provided in FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. A small firm, however, may operate on the cash basis, which means that revenue is recognized upon receipt of cash.
Receivables are of major concern to accounting firms. Proper aging and allowance estimates need be considered. Factoring or pledging of such receivables occurs infrequently in this service sector.
Perhaps one of the most significant revenue issues for accounting firms is the review and establishment of the proper “billable” hours criterion. An accounting firm, even a sole proprietor, should consider how the rate of the billable hour is set, what constitutes non-billable time, and the various billable rates, such as for a partner, an associate, a paraprofessional, a bookkeeper, and support staff. In large firms, non-CPA partners (known as principals) need to have a billable rate review as well.
As in most service sectors, there are local, state, and national trade associations. For example, practice aids for setting billable rates are found at the national level of the AICPA, the state levels through the respective state societies, and, to a degree, at local chapter levels. See, for example, the AICPA website at www.aicpa.org.
FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, applies as it does to accounting firms, requiring that revenue be recognized once earned and realized. Once the service is performed, the firm has earned the revenue. The billing is sent and receivables, with allowance estimates, control the cash features. If the firm is on the non-accrual basis (that is, the cash basis), then revenue is recognized upon actual receipt. All of the matters of setting billable rates, determining what is billable, etc., as covered in the accounting discussion above are relevant here.
Unlike accounting firms, many civil-trial-oriented practices have contingency-based revenue. For example, personal injury cases are often taken on a contingency basis. Here the client advances no funds other than expense reimbursements during the case and, upon a successful outcome, the law firm can take up to 40% of the recovery. If the result is unsuccessful, no funds are paid to the firm.
In such case, revenue is not recognized on an estimated basis or percentage of completion (PC) basis (see Chapter IND-II C, Construction Contracting, above). Doing so would violate the accrual basis in CON 5. Many law firms simply adopt a cash basis for reporting contingency-based revenues. This simplifies the revenue recognition process; however, some cases may take years before a jury verdict is obtained, and even then, the verdict is ordinarily subject to appeal. To show no revenue during this “dry spell” is problematic, so most contingency-fee-type firms will supplement their practice with ongoing shorter litigations such as for traffic offenses, or other with other practice areas such as wills.
Here the client signs a retainer agreement and pays a retainer that is used to “bill against” as services are performed. Any unused retainer is, by law, refunded to the client. Indeed the ABA rules and state bar rules demand that such retainer amounts be kept in a client trust account clearly identifying their true nature as client funds.
To characterize the retainer (as many clients do) as a form of deposit for financial accounting purposes is wrong. The retainer is still, in legal and economic substance, the client’s money and is unlike a retail deposit on goods or a builder’s deposit with an architect. Consequently, revenue is not recognized until the lawyer bills against the retainer for any fees earned by performing work.
It is not uncommon in some areas of law practice to require clients to pay a flat fee regardless of the outcome. This approach is generally found in criminal defense trial practices. Whether the case goes to trial, is dismissed, or, as is more likely, plea bargained, the firm retains the monies paid. The question, for revenue recognition purposes, is whether the firm that receives the flat fee (non-retainer) meets the CON 5 requirements. There is no issue that, at the point of payment, the firm has not earned its revenue. For instance, under an accrual basis, if the sole practitioner criminal defense lawyer dies the day after receipt of the flat fee, it is clear that no revenue has been earned. A conservative view would treat the revenue as recognized when the criminal matter is resolved.
This is probably why most criminal defense firms operate on the cash basis; that is, actual receipt of cash is the triggering event for revenue recognition. Revenue is recognized at the date of payment for cash-basis law firms, notwithstanding any legal requirements in the jurisdiction, since the client is purchasing the criminal defense firm’s expertise to resolve the matter and agrees that the fee is nonrefundable.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.