02 Nov How to Thrive as a 21st-Century Firm
If you believe accounting industry pundits, artificial intelligence and blockchain will decimate accounting firms the way an asteroid killed off the dinosaurs. But paleontologists don’t think dinosaurs really went extinct. They survived as today’s birds. In the next 10 years, or sooner, accounting and tax firms will evolve from offices full of employees dutifully typing data into workstations to organizers of terabytes of accounting data for our clients.
The pundits are wrong about our extinction. Effective project management will prepare your firm to thrive in the 21st century. I’ll take you there in a bit of a roundabout way via the coming of blockchain to the IRS.
Explaining basic blockchain technology is best accomplished via a very simple example. Let’s assume I have hired you to perform a service for me, and now I am ready to pay you. A blockchain makes this transaction secure and easy.
As the first step, we agree on the terms of the transaction. We agree on the service to be provided and the amount of the transaction. Once you perform the service, I send you a record of the proposed payment I intend to make to you. If you agree on the terms of the transaction, you send me an acknowledgment of the agreement and I pay you.
Here’s where blockchain technology creates a secure and credible transaction. Our communications contain a key unique to our transaction that is usable only for this transaction. Someone who intercepts the key will find it useless. Thus, the transaction is secure.
This technology is already a part of payment systems such as Apple Pay and Google Wallet. This prevents the type of fraud that victimized Target, in which someone intercepted payment data from their point of sale system. With blockchain technology, they can intercept all the data they want. They can do nothing with it.
Blockchain technology makes the transaction credible by recording it in a third-party ledger or database that neither of us can change. This is how Bitcoin works. Once we have agreed on the terms of the transaction and you have been paid, the transaction is unalterable history. Modifying the transaction requires that we agree to create a new transaction and add it to the blockchain.
Not only is the blockchain ledger kept by an independent third party, it is also duplicated across multiple databases to ensure that if one database is compromised, the other databases can act to reject any unauthorized modifications. Cool so far?
An example: 1099s
Now let’s look at the present process of creating 1099 forms and recording them with the IRS. Let’s go back to our transaction. I pay you for the service you provided and enter the data into my accounting system. You receive the payment and record it in your accounting system.
After year end, I create a 1099 form summarizing my year’s worth of payments to you and send one copy to the IRS and one copy to you. At the end of the year, you total all the 1099s you received, including mine, and file a tax return showing all of your income.
The IRS then compares all of the 1099s it has received for you to your tax return total revenue. If the totals match, woohoo! If your tax return total is higher than the IRS total, no problem. The IRS doesn’t care if you overreport revenue. If your tax return total is less than what you reported on your tax return, you get a nasty IRS bill.
What could possibly go wrong with this process?
Pretty much everything.
First, we have at least three possible sources of data entry errors: my accounting system, your accounting system and the IRS 1099 database. What are the odds all three systems will agree?
What’s the error rate on 1099s issued by vendors? That’s a hard number to pin down. The IRS certainly has no interest in finding out, because it treats 1099s as handed down on the stone tablets received by Moses. I’m about to represent a client in a tax court case because of a 1099 that was merely a half million dollars off. In my experience, the error rate on 1099s is substantial, and correcting all of the errors is nearly impossible.
The IRS sometimes fat-fingers 1099s. Electronic transmission of 1099 forms cuts down on errors, but a lot of 1099 forms are still submitted on paper.
Second, how often do vendors send a 1099 to the IRS but not to the customer? How often do 1099s get lost in the mail?
Third, the vendors and the customer may not agree on the necessity for a 1099 at all or might disagree on the proper box to be checked on the 1099.
Finally, anyone with your federal tax ID number can create a bogus 1099 form. Ask federal prosecutors and judges. They get 1099s all the time from the fine people for whom the prosecutors and judges have generously provided free accommodations in one of our finer federal penitentiaries.
Let’s look at the fundamental stupidity behind the process. The vendor takes analog data, check and payment information, and converts it into digital data in the vendor’s accounting system only to convert it back to analog data in the form of a paper 1099.
The customer takes the analog payment information and digitizes it into his accounting system. Then the customer takes the analog 1099 form received from the vendor and gives it to us to prepare a tax return. We take the analog 1099 form and convert it into digital form in our tax software, which then produces analog and digital versions of a tax return. The customer gets the analog version, and the IRS gets the digital version by way of the e-filing system.
How many times does the analog-to-digital conversion have to happen? Can it get any more stupid than this? If you’re angry about this, send your Congressman a 1099.
Here’s how blockchain technology will fix this process. First, before the payment happens, the customer and the vendor must agree on the terms of the transaction. That includes the amount and the nature of the transaction, such as whether the transaction is rent or non-employee compensation. No agreement, no transaction.
Second, once payment occurs, the transaction is recorded in a third-party ledger that neither side controls. Three parties have access to this independently recorded data: the vendor, the customer and the IRS. Everyone is reading one set of digital data. There are no opportunities for data entry errors. There are no analog-to-digital conversions. There are no bogus 1099s.
At tax return time, the customer gives his tax preparer access to the third-party ledger data. The tax preparer sucks this data directly into the tax preparation software with the knowledge that the IRS has exactly the same data. No more CP2000 letters. This gets me all choked up.
How close are we to this nirvana? I have no idea. Our country’s record with adopting large-scale digital financial systems is spotty. On one hand, the SEC has had moderate success with its EDGAR financial reporting system. On the other hand, large-scale electronic interfaces between vendors and customers haven’t caught on very well. Some companies, like Walmart, require vendors to use proprietary electronic payment systems. Proprietary is exactly what we don’t need.
I suspect that a number of private blockchain exchanges will arise and eventually merge into a national network. Or, the IRS could create its own blockchain ledger. Congress would have to appropriate money for the IRS effort, and the IRS would actually have to succeed with a major computer system installation. We all know how successful they have been in the past. They’re currently weighing the pros and cons of 3.5″ diskette drives.
The IRS is spending its time fighting Bitcoin instead of adopting the underlying technology. Of course, money from Congress would help. So, send another 1099 to your Congressman. Make certain there’s SE tax on this one.
Nonetheless, blockchain technology is coming to tax reporting. Why does that matter to you? Because your internal systems will have to change along with the financial and tax reporting systems. Let’s look at a very high level at how CPA and accounting firms work
Regardless of the type of service you provide, you
- take inputs in the form of data,
- process the data and
- create outputs such as tax returns and financial statements.
Currently, our inputs are largely analog. We receive paper or PDF forms. We then process this analog input into client deliverables such as tax returns and financial statements. In some cases, we convert the analog forms to digital before the processing happens. If you have scan and populate tax software, you are doing this. Still, we are using analog inputs.
Blockchain technology changes our inputs from analog to digital. To thrive in the 21st century, your systems must be able to easily convert to digital inputs from analog. If you have a back office full of tax preparers typing in W-2 and 1099 forms, you have a major transition in your future.
How your processes must change
Your whole paradigm of tax return preparation as data entry will change. Preparers will cease being data entry clerks. Clerical-level staff will validate streams of data. Preparers will use higher-level skills to make certain the data ends up in the best places.
For example, a preparer will determine the split of a 1098 form across Schedules A and E. Freed from basic data entry, preparers will look for tax-saving opportunities, such as pension contributions and switching accounting methods, that don’t exist in the data streams.
I’m guessing you don’t have a lot of preparers with the skills to decide whether switching from cash to accrual makes sense for a client. We don’t. If we do, I’m wasting a lot of time on review comments about this.
Soon, we’ll need fewer but more highly trained preparers. I have been telling our preparers for at least the last five years that the era of the data entry preparer is ending. Professional staff without higher-level skills will be out of the business.
Let’s take a look at a new tax preparation paradigm for the 21st century. I’ll ease you into this by looking at how another professional services industry has evolved. Let’s look at hospitals and how they have evolved into teams of specialists.
In the 1960s, when you went to the hospital, you were treated by two types of professionals: doctors and nurses. That’s all there were. Nurses did pretty much everything that doctors didn’t do. Nurses did everything from taking blood samples to checking blood pressure to changing bedpans. Doctors did, well, doctor things like look important and make the big decisions. Nurses did everything else.
If you haven’t been to a hospital since the 1960s, you might already be dead, but more likely you’ll notice a lot of changes in the 21st century. Modern hospitals divide patient care into a wide range of specialties. The person taking your blood pressure isn’t the one who changes your bedpan. There are transport specialists who move patients between rooms. There are dietitians to make certain you eat the right foods. There’s the ice water enema technician. There’s the specialist who shaves your nether regions, always a favorite. There are all kinds of different nurses. The operating nurses aren’t the same as the nurses in recovery.
And the doctors do, well, doctor things. Of course, there are all different kinds of doctors as well. You have pre-operation doctors, anesthesiologists, cardiac surgeons, intestinal surgeons, oncologists and hospitalists, who make certain nothing falls through the cracks.
In hospitals, people are trained to do one thing very well. You don’t want your cardiac surgeon performing your vasectomy. You don’t know what might get cut. A nurse trained in chemotherapy won’t help deliver your baby.
Now consider how we prepare tax returns. We give a preparer a file full of information and tell her to give us a perfectly prepared tax return. That return might have Schedules A, C, D and E. How likely is our preparer equally an expert in all of these forms? Some preparers are really good at earned income tax credits, but think section 179 is right next to the stadium bathroom. Some preparers are really good at lunch.
Why do we think this is the right way to prepare returns? What if we took a lesson from hospitals? Let’s have people specialize in one, or at most, a few areas. Let’s have Schedule A specialists, who are really good at excess mortgage interest calculations. Let’s have Schedule E specialists, who know the vacation home rules. Let’s have Schedule C specialists, who are experts at cash versus accrual analysis.
Here’s what this new workflow would look like.
- A client posts her tax return information to our portal / project management system.
- A clerical-level employee downloads the data, runs it through the scan and populate software, and validates the imported data.
- Because this return has Schedules A, B and D, it is routed first to our Schedule A expert and then to our investment income person, who works on Schedules B and D.
- Finally, a manager takes a big-picture look at the return for planning opportunities, and
- the return heads back to admin to be finalized and posted for the client.
Ready to change to this paradigm right now? I didn’t think so. I’m not either. There are a bunch of hurdles to overcome. I suspect we’ll all move in this general direction and eventually get there over time.
However, you probably have already moved in this direction without knowing it. Do you ever assign returns based on skills of specific preparers? Do you assign that really nasty Schedule C to Jane, because Jane is your best Schedule C person? Now ask yourself why you don’t do more of that.
“Well, Frank, if you’re so certain of this paradigm shift, why don’t you go first? Where’s your commitment?”
This fall I’m setting up a system to test this. In my theory, we can teach almost anyone to enter W-2 and basic Schedule A information. I’m considering hiring some fast-food workers, who are protesting for a $15 minimum wage. There should be a lot of them now that the automated ordering kiosks are replacing them. We’ll offer them $14.99 per hour.
Here’s how the math on this works. One $15-per-hour person can process three returns per hour, for which he validates the data from our scan and populate software, and then enters any remaining W-2 and Schedule A information. That’s $5 per return. If I have a $30-per-hour preparer doing this, I’m losing $5 per return. Over a couple of thousand returns, that’s real money. The savings will buy me an IPA or two.
If I were really genius level, I might consider hiring some student interns to do this. We could call it an apprentice program, which is what it would be. They don’t even have to be accounting students or even college students. As an aside, we’ve had great luck with students. They’re easier to train than the average oxygen waster off the street.
The point of this whole discussion was to impress upon you the need to create internal systems that can adapt to new business models. If you can’t systematize your business now, you’ll fall behind and never catch up. Here’s an unfortunate example of how fast our industry is moving.
We hire a lot of part-time staff during tax season. All of these staff work remotely. A couple of years ago, we hired two older gentlemen who had been out of the business for a few years and were hoping to earn some extra income in retirement.
Both washed out without ever completing a single return. Why? They couldn’t handle the changes in technology. One could never get his remote connection to work. The other is probably still looking for the magic button in our tax software that automatically fixes and imports QuickBooks data. Three years gone was too long.
We are hamsters on a wheel, and that wheel keeps accelerating. Run, hamster, run. I’m running right next to you.
The good news is that a lot of our fellow hamsters are about to fall off the wheel. Those of us who are dedicated to constant improvement will build organizations capable of thriving on change. Effective project management doesn’t just help you stay on the wheel. With effective project management, you’ll create a better and more profitable wheel.