Associate Break-Even: A Matter of Perspective

In my role as a consultant, I work with clients who wish to make critical business decisions but sometimes suspect the reliability of their internally generated numbers. Last month, Ed Wesemann wrote about just such a situation, when he referred to the common belief that associates do not make money in their first 3 years. Intuitively, this does not make sense to many law firm managers, yet their reports often support this contention.

Cash-Based vs. Accrual Accounting

The issue is a matter of perspective ' accounting perspective. Years ago, professional services firms were granted permission to report income on a modified cash basis, and for tax reasons most firms took that option. The misperception of associates not breaking even until their fourth year is less a matter of cost accounting and more an issue of using tax-based accounting for management decisions. Table 1 below illustrates this point.

[IMGCAP(1)]

In the typical cash-accounting view of the Table 1 scenario, an associate generates a cash net loss of $89,000 in year 1. The associate's cash net income amounts in years 2 and 3 are not sufficient to cover the loss in year 1, resulting in a year 3 cumulative cash loss of $5,957. This illustrates the often-heard conclusion that an associate does not make money for the firm in the first 3 years.

What is missing from the tax-based report perspective is the fact that the associate worked hours that are not yet collected, but have value to the firm nonetheless. Regardless of whether the associate were to leave at the end of year 3, the remaining uncollected time would be billed and collected in year 4, resulting in a positive lifetime net income for that associate.

Accrual accounting does not ignore the value of time worked but not yet collected; instead, revenue is equal to time worked multiplied by an assumed effective collected rate.

If we look at the true economic return of the associate using accrual accounting as opposed to tax reporting, we see that the small loss generated by the associate in year 1 is more than offset by profits in the second year. That is, the associate in this scenario breaks even part way into year 2. The exact break-even point depends upon the actual hours worked, billing and realization rates, associate compensation and overhead allocations.

The Matching Principle

For profitability reporting, moreover, it makes sense to apply an additional perspective called the matching principle. The matching principle states that expenses incurred to generate revenue should be recorded only when the revenue is recognized in the financial statements (the idea is that revenue recognition is deferred until the actual collection amount is known with certainty). Using this accounting principle, revenue is recognized when collected and the related expenses incurred to generate the revenue are essentially capitalized and expensed as the revenue is realized (collected).

Using year 1 as an example, the associate worked 1,200 hours and incurred $215,000 of total expenses, resulting in a (rounded) cost per hour of $179 ($215,000/1,200). The firm collected $140,000 in revenue for 800 hours worked. The cost for the 800 hours was $143,200 (800 * $179). Under cost accounting with the matching principle, the associate's net loss in year 1 is a much lower $3,200 ($140,000 – $143,200).

Conclusion

It is important that management choose the appropriate accounting information, depending on the decision to be made or the issue to be resolved. Tax-based cash statements are appropriate for tax reporting and partner distributions. Most management decisions, however, should use the matching principle for expense recognition. In particular, when we match associate expenses with the stream of revenues generated, we see from an economic point of view that associates make a positive contribution far earlier in their careers.

Please contact the author if you would like a copy of the above Excel model to adjust for your firm's assumptions. For another comparison of cash vs. accrual accounting for associates, see the ABA-published book Compensation Plans for Law Firms 4th edition, by James D. Cotterman.

In my role as a consultant, I work with clients who wish to make critical business decisions but sometimes suspect the reliability of their internally generated numbers. Last month, Ed Wesemann wrote about just such a situation, when he referred to the common belief that associates do not make money in their first 3 years. Intuitively, this does not make sense to many law firm managers, yet their reports often support this contention.

Cash-Based vs. Accrual Accounting

The issue is a matter of perspective ' accounting perspective. Years ago, professional services firms were granted permission to report income on a modified cash basis, and for tax reasons most firms took that option. The misperception of associates not breaking even until their fourth year is less a matter of cost accounting and more an issue of using tax-based accounting for management decisions. Table 1 below illustrates this point.

[IMGCAP(1)]

In the typical cash-accounting view of the Table 1 scenario, an associate generates a cash net loss of $89,000 in year 1. The associate's cash net income amounts in years 2 and 3 are not sufficient to cover the loss in year 1, resulting in a year 3 cumulative cash loss of $5,957. This illustrates the often-heard conclusion that an associate does not make money for the firm in the first 3 years.

What is missing from the tax-based report perspective is the fact that the associate worked hours that are not yet collected, but have value to the firm nonetheless. Regardless of whether the associate were to leave at the end of year 3, the remaining uncollected time would be billed and collected in year 4, resulting in a positive lifetime net income for that associate.

Accrual accounting does not ignore the value of time worked but not yet collected; instead, revenue is equal to time worked multiplied by an assumed effective collected rate.

If we look at the true economic return of the associate using accrual accounting as opposed to tax reporting, we see that the small loss generated by the associate in year 1 is more than offset by profits in the second year. That is, the associate in this scenario breaks even part way into year 2. The exact break-even point depends upon the actual hours worked, billing and realization rates, associate compensation and overhead allocations.

The Matching Principle

For profitability reporting, moreover, it makes sense to apply an additional perspective called the matching principle. The matching principle states that expenses incurred to generate revenue should be recorded only when the revenue is recognized in the financial statements (the idea is that revenue recognition is deferred until the actual collection amount is known with certainty). Using this accounting principle, revenue is recognized when collected and the related expenses incurred to generate the revenue are essentially capitalized and expensed as the revenue is realized (collected).

Using year 1 as an example, the associate worked 1,200 hours and incurred $215,000 of total expenses, resulting in a (rounded) cost per hour of $179 ($215,000/1,200). The firm collected $140,000 in revenue for 800 hours worked. The cost for the 800 hours was $143,200 (800 * $179). Under cost accounting with the matching principle, the associate's net loss in year 1 is a much lower $3,200 ($140,000 – $143,200).

Conclusion

It is important that management choose the appropriate accounting information, depending on the decision to be made or the issue to be resolved. Tax-based cash statements are appropriate for tax reporting and partner distributions. Most management decisions, however, should use the matching principle for expense recognition. In particular, when we match associate expenses with the stream of revenues generated, we see from an economic point of view that associates make a positive contribution far earlier in their careers.

Please contact the author if you would like a copy of the above Excel model to adjust for your firm's assumptions. For another comparison of cash vs. accrual accounting for associates, see the ABA-published book Compensation Plans for Law Firms 4th edition, by James D. Cotterman.