Law Firm Accounting (#279)
/In this podcast episode, we discuss the accounting for law firms. Key points made are noted below.
The Basis of Accounting
A law firm is not in the business of spending a lot of its resources on accounting, so the smaller ones use the cash basis of accounting, to keep things as simple as possible. Larger ones that have a decent-sized accounting staff usually switch over to the accrual basis of accounting.
Client Billings
Next, the essential ingredient in law firm accounting is billings to clients, which is hours worked, multiplied by the billing rate for each person on staff. To calculate billings, each employee has to charge his or her time to a charge code, which at least identifies the client, and probably also a specific activity, so there might be a sub-level charge code for trademark work, and another charge code for dealing with specific lawsuits, and so on. For a detailed listing of codes, you might want to look up the Litigation Code Set online, which provides codes for things like fact investigation, and pleadings, and oral arguments.
The coding can also be separated by practice group within a law firm. In a larger firm, there could be upwards of 30 practice groups, such as arbitration, franchise law, and securities law, so this could be an important differentiator in a larger firm.
So, getting back to the billing process. It’s not actually as simple as multiplying hours worked by the billing rate. They also consider the efficiency of the people conducting the work, and the value of the services provided. The result might be a billing amount that exceeds the standard rate that would normally be charged, but more likely it’s a reduced billing. If the billing exceeds the standard rate, the difference is called over-realization. If the billing is less than the standard rate, the difference is called under-realization.
And then we have the timing of billings. One approach is to require a retainer, where clients pay in advance for services that will be provided at a later date. This approach wipes out any cash flow issues for the law firm, but clients might not be too happy about it. A more common approach is progress billings, where billings are issued immediately after month-end, based roughly on hours worked during the month. And finally, there’s the single billing at the end of work, which is what it sounds like. Single billings are usually confined to very short projects – otherwise, the firm might not be able to support the related negative cash flows.
Billing is the single most important accounting issue. But, it also makes sense to group employee compensation by practice group. The reason is that you can then construct income statements by practice group, where billings and compensation cover practically everything.
Compensation Reporting
And then there’s compensation reporting. Since this is by far the largest expense of a law firm, it makes sense to view it as many ways as possible, to see if there’re any anomalies to investigate. For example, you could track average compensation for groups of employees, based on the number of years since they graduated from law school, to see if there’re any outliers. Or, track the cost of time not charged to clients, or the cost of any people not assigned to specific practice groups.
Reimbursable Costs
Another topic is reimbursable costs. Law firms tend to incur costs on behalf of their clients a lot more than in other industries, so they need a good system for identifying and recording these costs by client, as well as to bill clients for reimbursement. For example, they may need reimbursement for travel expenses, filing fees, and court costs. When a law firm incurs these costs, it records them in a client disbursements receivable account, which is an asset account. When clients reimburse the firm, the payments offset the receivable, so these payments are not recognized as revenue, and there’s no impact on the reported amount of profit or loss. The only exception is when a client refuses to pay back the firm, in which case the unpaid amount is charged to expense.
Distributable Income
And then we have the concept of distributable income. From the perspective of a law firm partner, the main financial statement line item is not net income, but rather the amount of distributable income. This is the amount of net income that’s available for distribution to active partners. This amount is usually less than net income, where the difference is the amount paid out to former partners in the firm.
Types of Receivables
Moving on to receivables. In most industries, there’s just trade receivables. In a law firm, though, there’re three types of receivables. The most obvious is fee billings to clients, which are billable hours that have been formally assembled into an invoice and issued to a client. In addition to that, it has unbilled fees, which are hours charged to client matters, but which have not yet been billed. At month-end, this could be a fairly large amount, depending on billing practices. And finally, there’re client disbursements receivable, which are costs incurred by the firm on behalf of clients, and which have been billed to the clients.
Reserves for Receivables
If a law firm uses the accrual basis of accounting, this triple receivable situation means that it needs to maintain a more complex set of reserves for receivables. There should be an allowance for doubtful accounts, which is the usual reserve against billings for which the firm never receives payment. Nothing new there. But, it may also need a reserve for estimated unrealizable amounts. This is for when the partners decide not to include some billed hours in the billings that are eventually issued. This might be because the partners don’t want to exceed a certain amount of billings with certain clients, or perhaps because they feel that the work was inefficiently performed. In these cases, the reserve is set aside for estimated unrealizable amounts. This approach is totally unique to professional services firms.
Both reserves can be difficult to estimate, for several reasons. First, a client is less likely to pay the entire amount of a billing if its relationship with the firm is fairly weak, or if it’s new to the relationship, or it’s having financial difficulties. And, the reserve for estimated unrealizable amounts is hard to determine when the firm has a large proportion of new associates and paralegals, who are more likely to be inefficient.
Partner Accounts
The final accounting issue is partner accounts. Each partner has a capital account, which is used to track the net investment balance of the partners. This account involves pretty much what you’d expect for a partnership, which begins with the investments made by the partners, with additions for profits made by the law firm, and reductions for payments made to the partners.
Management Reports
And then we have the management reports. I’ll point out a couple. Of course, there’s the unpaid billings report, which is a receivable aging report that’s usually broken down by the responsible partner. Partners spend a lot of time on this one.
Next, we have the chargeable hours report, which compares the actual chargeable hours by employee to either an historical average or some sort of budget figure. Partners use this for capacity planning, since low chargeable hours might trigger a layoff, and high chargeable hours is a warning flag to hire more people.
Another possibility is the lawyer leverage ratio, which compares the number of partners to the number of all other lawyers in the firm. The partners make more money if they have a large base of legal staff, but if they run up that ratio too far, then the staff won’t see a clear path to partnership, and they’ll leave.
And finally, there’s the realization rate. This’s the proportion of billable hours at standard billing rates that’s actually billed to clients. This rate can be broken down by employee classification, since junior employees tend to be less efficient, so fewer of their billable hours are billed to clients. This can be a major driver of profitability, so partners tend to keep a close eye on it.