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counting. Accrual accounting requires revenues to be recognized when
earned and costs to be expensed when incurred, without regard to the
time period in which cash is received or payment is made. Cash basis ac-
counting, which does not follow the matching principle described ear-
lier, recognizes revenue when cash is collected and expenses when they
are paid in cash. Because the cash basis does not follow the matching
principle, it is not GAAP; however, some form of it may be used in spe-
cific cases for income tax purposes, particularly in partnerships.
• Book versus tax: Financial statements prepared for management and in-
vestors normally are referred to as the official “books” of the firm. Al-
though large firms should always follow GAAP and prepare financials
using the accrual method, smaller firms that are not publicly traded
may employ either the cash or accrual basis of accounting or a hybrid
thereof that best suits its business purpose relative to the cost of adher-
ing to a full accrual system. Use of the cash method frequently defers
income taxes because revenue is not recognized until collected, and ex-
penses, particularly personnel costs, are deducted when paid. However,
when preparing tax returns, a specific set of rules set forth by federal,
state, and local taxing authorities must be followed. When tax meth-
ods are used for “book” purposes in the preparation of financial state-
ments, the firm will invariably report results different from those
prepared using GAAP. Such differences include depreciation and
amortization methods, limits on executive compensation, allowable
meal expenses, pension expenses, and the tax calculation itself.
• Revenue recognition: As stated earlier, under GAAP, revenue should be
recognized when it is earned, not when an agreement is made or cash is
collected. Many of the accounting scandals that have occurred over
time have involved material problems with the timing of revenue recog-
nition. When in doubt, a good general rule of thumb to follow is to de-
termine whether it would be likely that a judge would order your client
to pay you solely based on the work performed through the closing date
of the financials”without any further work being completed. To an-
swer that question affirmatively, client compensation agreements need
to be written carefully to ensure that revenue can be recognized in tan-
dem with costs incurred (i.e., the matching principle).


The Matching Principle
A mid-size Western professional services firm that used the calendar
year for its financial statements performed a variety of services for its
client, normally using separate written agreements to summarize the
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Finance, Accounting, and Human Resources

scope of work and compensation terms. The client™s fiscal year began on
December 1 each year, and the annual letter agreements were written
with that December 1 start date. For many years, the firm recognized
the full 12-month value of the contract in December, in effect taking 12
months of revenue for only one month™s work (payment was made quar-
terly over the year). During the remaining 11 months, the firm did not
recognize any revenue even though it continued to employ staff to serve
its client. This situation clearly conf licted with two accounting princi-
ples”revenue recognition and matching.

• Expense recognition: Expenses should be recognized in the financial
statements during the period to which they pertain. In general, this
means that costs should be expensed in the month in which an irrevoca-
ble commitment was made to secure the goods or services, unless it
qualifies for special capitalization treatment. Capital items are gener-
ally assets that are material in value (e.g., over $1,000) and have a use-
ful life in excess of one year. Unless a purchase meets both those
criteria, in general, it should be expensed in the month incurred (not
necessarily the month paid).

Value of Labor
The same professional services firm capitalized the significant cost of
temporary help used to help prepare a proposal to a client during the
fourth quarter. Financial managers in the firm based that decision on
the argument that the cost was material and, under the matching princi-
ple, the value of that labor would benefit the firm for many years to
come if it won the proposal. This treatment, which did not conform to
GAAP because such costs should always be treated as period costs and
expensed immediately, resulted in an overstatement of profit during the
year the costs were incurred.

• Audits versus reviews versus compilation services: CPAs offer three
types of accounting services: audits, reviews, and compilations. Audits
are comprehensive reviews of a firm™s financial statements and are re-
quired of publicly held companies. Other organizations may secure au-
dits of their financials if they are in a position of public trust, have
multiple investors, or if required by other creditors. Because of the
amount of time involved in testing the firm™s internal controls and a suf-
ficient percentage of its transactions, audits are the most expensive
of the three types of services, but yield the highest level of assurance
that the financials conform to GAAP and that the system of internal
controls is satisfactory to protect the assets of the organization.
Reviews of financial statements are just that; the CPA conducts a
relatively high-level review of the financial statements and reports his
356 The Back Office: Efficient Firm Operations

or her findings in a letter report but does not opine that the statements
present fairly the financial position of the firm in accordance with
GAAP as he or she would in an audit. Reviews, which in general are
more appropriate for small closely held firms, consist of an analysis of
the statements, noting the reason for significant variances and an over-
all test for reasonableness. In general, a review would not include a de-
tailed study of internal controls nor would it involve extensive testing of
account balances, but it does provide owners with a basic level of as-
surance that the financials generally conform to GAAP.
Compilations, as the name suggests, involve the CPA acting in the
client role of assisting in the preparation, or compilation, of the financial
statements themselves. Because the CPA essentially prepares the state-
ments based on the balances presented in the books and does not per-
form testing of the underlying data, the CPA does not opine as to the
fairness of the statements themselves because it would be a conf lict in
his or her attestation duties. In general, this is the least expensive service
but also provides investors with the lowest level of assurance that the fi-
nancials conform to GAAP. However, in a small, closely held firm, a com-
pilation may be more than adequate to meet the needs of the owners.

In summary, executive management that supports the broad accounting
principles and issues outlined earlier should, over time, build a credible finan-
cial foundation as well as strong fiscal footing that will add value to the firm.

Accounting Systems
Accounting systems for professional services firms come in all shapes and
sizes. Industry-specific systems, tailored to the nuances of the general re-
quirements of the industry, offer enhancements to facilitate management of
financial and operational needs beyond that offered by relatively generic ac-
counting packages such as QuickBooks, Turning Point, Peachtree, Everest,
and Microsoft CRM. Although in recent years these programs have been tai-
lored to specific industries such as professional services, in general, they are
not scalable beyond a dozen or so accounting employees and may not meet
the specific needs of your clients or business. However, these packages can,
for a relatively modest investment, meet the basic needs of many profes-
sional services organizations until they reach a point where the accounting
department exceeds a dozen employees.
After that point, more robust financial packages may be in order, such as
Solomon IV, MAS90, MAS 200, Lawson, and Microsoft Great Plains, among
many others. Before any system is selected, the firm should prepare a de-
tailed list of its financial accounting, reporting, and budgeting needs, and
then use that list to ensure that whatever package is selected will meet all es-
sential and important requirements. Because the total cost to convert to a new
system can be more significant than the upfront cost of the software itself,
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Finance, Accounting, and Human Resources

time and money is well spent at the outset in ensuring that a package is se-
lected that best fits the firm™s needs within the current budget.

Managing the Balance Sheet
Every executive maintains a certain style and set of managerial tools close at
hand with which he or she governs. Because most people can relate to the
concept of making a profit, they are reasonably comfortable with it and rely
first and foremost on the profit and loss statement (P&L) as their guide to the
firm™s financial performance. However, a strong P&L may not necessarily
mean that the firm is in a strong financial position because many potential li-
abilities may be hung up within certain balance sheet accounts. Concepts in-
herent in the balance sheet require a slightly more technical understanding of
accounting, and many executives fail to review it in detail, or at all, and miss
many of the key economic indicators of the firm™s relative financial health.
When a balance sheet is well managed, the integrity of the P&L is main-
tained. Depending on the size of the organization, millions of dollars can be
hung up or never recorded on the balance sheet that, if not addressed in a
timely manner, can overwhelm otherwise well-managed firms. In this sub-
section, we address some of those key balance sheet components that should
be watched carefully by every professional services firm executive.

ACCOUNTS RECEIVABLE (A/R). A /R represents amounts billed /invoiced
to clients or customers that have yet to be paid as of the closing date of the
financial statements. At a minimum, executive review of three key items is
critical: (1) the absolute change in balance from prior periods, (2) the change
in balance relative to changes in revenue or other client billings, and (3) the
aging of billings to specific clients. The objective of this review is to ensure
that all accounts are collectible and that adequate reserves have been estab-
lished to cover all potential bad debts. Further, and equally important, by
conducting regular executive reviews of the aging, staff responsible for col-
lecting invoices are more likely to be proactive in taking effective collection
actions sooner if they know management is focused on this key metric. When
comparing against prior periods, management should evaluate the change in
balance from the prior month, beginning of year, and same period a year ear-
lier to better understand the macrolevel elements responsible for the major-
ity of the change. When reviewing the detailed aging report by client, all
extraordinarily large balances should be evaluated as well as any balance
over 30 days past due. Many companies today unilaterally extend payment to
45 days knowing that little, if any, adverse consequence is likely to occur by
being two weeks past due. However, once a receivable extends beyond the
30-day past due column, some sort of problem most likely exists, such as:

• Invoice is sitting on the desk of someone who may have forgotten
about it.
358 The Back Office: Efficient Firm Operations

• Invoice was never received or is lost.
• Invoice was sent to wrong person and recipient fails to forward it to the
responsible person.
• Invoice was sent to the right person, but that person is either on an ex-
tended leave or no longer works for the company.
• Invoice contains a billing error or questionable item on it, and client re-
fuses to pay until the item in question is removed from the bill. Even
though the majority of a bill is correct, some clients refuse to short pay
the undisputed portion under the belief that it will give them more
leverage in correcting the error or questionable item.
• Work was never authorized in writing, and a valid purchase order was
never issued even though the client™s representative verbally autho-
rized the work.
• Client is maximizing their cash position.
• Client is in financial difficulty and may not be able to pay.

All of these items, arguably with the exception of the last issue that relates
to a client™s creditworthiness, can be managed effectively with phone calls,
meetings, and constant follow-up. The longer an invoice remains unpaid, the
higher the probability it may never be paid, thus it is critical to the firm™s cash
f low to constantly monitor its receivables position. Many of the actions a firm
can take to collect amounts owed to it in a timely manner may be intuitive to
seasoned professionals, but lower level staff responsible for those collection ef-
forts may benefit from a list of clearly stated objectives and strategies, includ-
ing many of those listed below. It is important to recognize that each firm is
different with respect to the composition of its client base and the volume of
invoices issued to each. Accordingly, the following list of collection efforts
should be tailored to the appropriateness of each firm™s situation:

• Maintain a consistent billing schedule so that clients know when to ex-
pect their invoices and, whenever appropriate, tailor that schedule to
dovetail with a client™s accounts payable process. Time the release of
your invoices to best coincide with the client™s internal accounts
payable payment schedule, thus minimizing the amount of time your in-
voice is held within the client™s payment process/system.
• When the promptness of payment has been a problem in the past for a
particular client due to routing/approval issues, call the client a few
days after mailing to ensure that invoices have been received.
• For larger clients, ensure that your billing and collection personnel
know the client™s internal payment procedures, who to contact, and the
person(s) responsible for mechanically paying the bills. Development of
a close relationship between these individuals can significantly improve
the timing and collection of cash, thereby increasing interest income
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Finance, Accounting, and Human Resources

and decreasing interest expense. If the client is not located nearby,
schedule an economical f light for your billing and collection staff to
make a trip to the client™s offices at the outset of the relationship to es-
tablish a bond that will yield significant dividends (particularly if the
client is large enough and an ongoing relationship is expected).
• Your CFO, controller or top financial executive should know senior fi-
nancial executives at the client well enough to pick up the phone and
discuss any payment delays.
• When practicable, hand deliver invoices that may have unusual items on
them, and take a few minutes to sit down with the payment contact to
ensure that they understand the issues surrounding the anomaly.
• When appropriate, call the client within 10 days of an invoice due date
or before it will roll into another aging category to prompt payment, par-
ticularly before an invoice rolls into its first overdue category (e.g., 50
days from invoicing).
• When requested to send invoices directly to the main client, send a list of
invoices to the finance contact so that he or she has a summary of in-
voices sent in order to help track the invoices internally. When requested
to send invoices directly to the financial contact, send the summary to
the main client to keep him or her aware as well.
• Understand the client™s payment process, and ensure that if POs are re-
quired, all invoices are properly matched with their respective POs be-
fore mailing the invoices to avoid delays in processing.
• Set the pace of communication by returning all calls within an hour of
a client™s returning your call. By setting such a pace, you communicate
to the client the importance of your efforts, that you will manage that
process in a professional manner, and you inherently appreciate the
same treatment from them.
• Correct billing errors quickly and err on the side of making immaterial
concessions to clients when payment liability is less than crystal clear.
• Ensure that your staff has a clear understanding as to who holds pri-
mary responsibility for invoice collection (e.g., finance or another
client-facing firm employee). Measure their performance and graph it.
Review those graphs monthly and acknowledge and reward good collec-
tion results (as opposed to efforts), for example, less than 1 percent of
all billings being past due.

Many unpaid invoices never should have been issued in the first place,
and professional firm executives should investigate and understand fully
the chain of events that resulted in an invoice being rejected for payment.
In most cases, that investigation will uncover internal operational issues

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