“Print a P&L (profit and loss statement) for me,” I said.

She’s quick with the laptop, and her Brother laser printer came to life. The single page slid right out.

She had asked me to help her with the finances of her small firm. Apparently, she had thought things were going reasonably well, but she couldn’t figure out why she wasn’t taking home what she’d hoped.

I scanned down the P&L. Things were looking pretty good. Her revenue was reasonable, and her expenses were being covered. She was showing a bit of money left over as we drifted down to the bottom line.

I was feeling pretty good about her situation until she mentioned…the drawer.

The drawer?

Yep, that’s what I asked her. “What drawer?”

That’s when I noticed that the P&L said “cash” in the upper right-hand corner and not “accrual.”

She explained that they keep the unpaid invoices in a locked drawer in her assistant’s desk. The assistant has a folder called “payables,” and the invoices go straight there when received in the mail or e-mail.

I asked her to open the drawer. After a few minutes of hunting for the key (cleverly hid in the pen/pencil box on the desk), we unearthed a big pile of invoices.

And by “big pile,” I mean “BIG PILE!”

There were a bunch of invoices in the pile—many of them for substantial amounts, and some of them reflecting past due balances.

I dug through, and a cold chill ran through my body. I realized the P&L was utterly worthless. It didn’t reflect the expenditures reflected on these invoices. The invoices had never been entered in the accounting system.

We spent the next week fixing things. We entered all the old invoices and started entering the new invoices as they arrived. We stopped printing “cash” basis P&Ls and started printing “accrual” basis reports.

Suddenly, the data we’re reviewing reflected reality instead of the fantasyland you see when you review reports that don’t include all the pieces of data. If you leave out a “drawer” full of invoices, you’re leaving out an important detail.

Now, with the invoices entered, we’re looking at what’s really happening.

The cash basis reports simply showed the money coming in and the money going out—but only when it actually went out. If the invoices were left unpaid in the drawer, then they didn’t show up as an expense. It looked like we were more profitable than we were because we weren’t paying the bills.

The accrual basis reports now show the invoices coming in and the invoices going out. They show what’s happening without regard to what’s actually going on in the bank account. They’re not a good indicator of our cash position, but they show us what we’re billing and what we’re spending. They’re a different, and usually more accurate, reflection of reality.

Three Ways to Handle Finances

You’ll find different law firms record their accounting data differently. It’s all good, if you understand it. Any system is fine if it helps you understand what’s happening so you can make evidence-based decisions on what to do next. The key is understanding your system and accounting for what’s in the drawer.

On income and expenses, I’ve encountered three approaches in my visits to law firms.

1. The Drawer

This approach isn’t uncommon. I’ve met lots of lawyers who record payables when they pay them. This is a bad idea. Don’t do it.

2. Cash Basis

Some firms record everything and then look at cash basis reports. This is fine as long as you’re monitoring your balance sheet in addition to your P&L. You need to watch your cash flow carefully so you don’t run out of cash when payroll is due.

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3. Hybrid: Cash/Accrual

Personally, I like this approach. Some firms record all the invoices and look at the P&L as an accrual basis report showing what was spent each month, regardless of whether it was paid. However, they don’t record invoices sent to clients. They only record payments when received. Basically, they’re recording cash when it comes in and expenses when they’re incurred. The “drawer” is filled with unpaid client invoices. They take the position that an unpaid client invoice has no value (which is often not far from the truth).

The Key to Mastering Your Finances

The key here is to understand this stuff. You need to know when you’re doing well based on your reports rather than based on your bank balance. And this is critically important: you need to have advance warning when things are going poorly. Growing your business is ALWAYS preceded by understanding your business. You can’t grow what you don’t know (reminds me of “if the glove doesn’t fit…).

I’d love to tell you that you should spend some time with your accountant and talk this all through. I wish I could say accountants are good at explaining accounting, and yours will explain all of this in detail as it applies to your situation. Sadly, my experience of accountants is that they’re mostly horrible at speaking to other humans. Good luck finding one who can help you.

My advice is that you actually learn some accounting yourself. It’s an important prerequisite to operating a business. That’s why it’s one of the first courses taken in pursuit of any business degree. I guess accounting matters. Who knew?

The next time you print a P&L, the goal is for it to provide you with useful, valuable guidance you can use to make decisions. Next time, you’ll know that the report reflects reality and that you don’t have to look in “the drawer” to find out where you really stand.