Cash versus accrual basis of accounting: GAAP call for the financial records of an organization to be maintained using the accrual basis of accounting. 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 accounting, which does not follow the matching principle described earlier, 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 specific cases for income tax purposes, particularly in partnerships.

Book versus tax: Financial statements prepared for management and investors normally are referred to as the official books of the firm. Although 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 adhering to a full accrual system. Use of the cash method frequently defers income taxes because revenue is not recognized until collected, and expenses, 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 methods are used for book purposes in the preparation of financial statements, 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 recognition. When in doubt, a good general rule of thumb to follow is to determine 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 answer that question affirmatively, client compensation agreements need to be written carefully to ensure that revenue can be recognized in tandem 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

scope of work and compensation terms. The clients 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 months work (payment was made quarterly 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 conflicted with two accounting principles-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 irrevocable commitment was made to secure the goods or services, unless it qualifies for special capitalization treatment. Capital items are generally assets that are material in value (e.g., over $1,000) and have a useful 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 principle, 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 firms financial statements and are required of publicly held companies. Other organizations may secure audits 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 firms internal controls and a sufficient 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

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 overall test for reasonableness. In general, a review would not include a detailed study of internal controls nor would it involve extensive testing of account balances, but it does provide owners with a basic level of assurance 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 statements based on the balances presented in the books and does not perform testing of the underlying data, the CPA does not opine as to the fairness of the statements themselves because it would be a conflict 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 compilation 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 financial 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 requirements of the industry, offer enhancements to facilitate management of financial and operational needs beyond that offered by relatively generic accounting packages such as QuickBooks, Turning Point, Peachtree, Everest, and Microsoft CRM. Although in recent years these programs have been tailored 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 professional 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 detailed list of its financial accounting, reporting, and budgeting needs, and then use that list to ensure that whatever package is selected will meet all essential 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,