OSB Professional Liability Fund

The Basics of Your Financial Statements

March 22, 2019
by Sheila Blackford

The three most important financial statements that lawyers should pay attention to are the income statement, the balance sheet, and the statement of cash flows.  These reports will not only help you run a profitable law practice, they also will help you to provide current reports to your business loan officer if you plan to get a business loan.
 
Most law firms use an accounting program, such as QuickBooks, which will be able to generate these reports easily because the program helps you correctly record your financial transactions. Double-check all numbers to ensure that you have entered them correctly.

The Income Statement

The income statement is important because it shows how profitable your law firm has been during the time period shown in the statement’s heading, typically for the month, the quarter, or the year. Select the starting and ending dates for whatever time period you choose to review. You will be able to see your financial trends by reviewing your income statement on a quarterly basis and comparing these quarterly income statements with each other.
 
You may think that since this report is called an income statement, it would record cash coming into your law firm.  Welcome to the world of accounting. In reality, the income statement’s purpose is to report the profitability of your law firm (by reporting revenues earned by your law firm during the reported time period) and to report the expenses incurred by the law firm during that same time period. The difference between income and expenses is stated as net income or net loss and is commonly referred to as the “bottom line.”
 
When first setting up your accounting program, such as QuickBooks, you will be asked how you keep your business books, on a cash basis or accrual basis. Most law firms in the United States elect cash basis, but you should understand these two options so that you make the choice that makes sense to you.

Accrual Basis of Accounting

Under the accrual basis of accounting, revenues are recorded when they are earned (i.e., when the work is completed and the bill is sent), not when the law firm receives the money. Essentially, you have accrued the right to the income. A business using the accrual basis of accounting recognizes income when the right to that income occurs, i.e., when it is earned.
 
It is important to realize the tax ramifications of being on the accrual basis. Because you have recognized the income when you accrued the right to receive that income, you are taxed as though you had already received the income. Certainly, you will later make an adjustment for the bad debt if the client does not pay. The point here is that your liability for tax is when the income is recognized, which is when the right to it accrues, even if you do not yet have the money in hand.
 
Under the accrual basis, an expense is recognized when the obligation to pay that expense is incurred. Because of the matching principle, the expense is recorded with the matching revenue. Most manufacturing businesses use the accrual method of accounting because it better illustrates profitability by matching expenses with the income those expenses helped to generate.

Cash Basis of Accounting

In the cash basis of accounting, income is recognized when the income is actually received, and expense is recognized when the expense is actually paid. Under the cash basis of accounting, revenues are recorded when they are received, not when they are earned by the law firm. A business using the cash basis of accounting recognizes income only when payment is received.
 
It is important to realize the tax ramifications of being on the cash basis. Because you only recognize the income as you receive the money, you are only liable for income tax if you have received the income. Thus, your liability for tax is when the income is actually received. The downside of the cash method is that profitability on a particular matter is harder to determine because it may take place months, or even years, before income from that matter is received.
 
Under the cash basis, an expense is recognized when the expense is paid. There is no matching of expenses with the income those expenses helped to generate. You can see that, unlike the accrual basis, the cash basis does not clearly illustrate profitability. You will have to do a bit of searching to be able to allocate the profitability of a law practice area or timekeeper.
 
Many lawyers setting up their accounting software will elect to set up their books on the cash basis because that is what is most familiar. We run our personal finances on a cash basis and prepare our personal income tax returns based on how much we were paid and how much we paid in deductible expenses. Income is when we receive our paycheck. Expense is when we pay our mortgage.

The Balance Sheet

The balance sheet is important because it provides a snapshot of your law firm’s financial position at a given point in time, typically at the end of the month, the end of the quarter, or the end of the year. It can be whatever point in time you need a snapshot. You will see more of your financial trends by reviewing them on a quarterly basis.
 
The balance sheet will only show where things stand on a specific date. It reports the law firm’s assets, liabilities, and the owners’ equity or stockholders’ equity at a specific point in time a opposed to over time.
 
If you are looking at your law firm’s balance sheet dated December 31, then the amounts shown are the balances in the accounts after all transactions pertaining to December 31 have been recorded.

The Statement of Cash Flows

The statement of cash flows is important because it shows how your law firm’s cash amount has changed during the time interval in the statement’s heading.
 
For planning purposes, it is helpful to be able to see the cash generated and used by the law firm’s operating activities, any investing activities, and any financial activities.
 
Like the income statement, the statement of cash flows is concerned with a time interval rather than a point in time, typically for the month, the quarter, or the year.  Select the starting and ending dates for whatever time period you review. You will see more of your financial trends by reviewing them on a quarterly basis. If you operate your firm on the cash basis, your statement of cash flows and your income statement will be essentially the same. If you operate on an accrual basis, the statement of income and expenses provides a clearer picture of actual cash flows.

Becoming a Good Financial Manager

Your biggest role will likely be monitoring the monthly reports of your law firm’s income and expenses and monitoring the monthly reports for each client or third party’s subaccount in your lawyer trust account. You must be able to properly monitor the accuracy of any reports pertaining to your trust account even if they are prepared by a trained bookkeeper, because you cannot delegate the full responsibility for the lawyer trust account. You remain ultimately responsible for your lawyer trust account. In a similar vein, your bookkeeper’s role is to gather accurate account numbers and prepare reports for you to review about the overall finances of your law firm.
 
By understanding these three most important financial statements—the income statement, the balance sheet, and the statement of cash flows—you will have a consistent view of your law firm’s profitability. And your accounting program, such as QuickBooks, will include these three statements in its “Reports” feature.