April 1, 2005
Cash Flow vs. Income
I am always surprised by the number of law firms whose only financial view of their law practice business is a cash view. Most law firms keep their books and records on a cash basis.
Cash basis financials are misleading views of the business. And worst, they hide trends; thus, preventing management action in time to make a difference. Cash statements do not match revenues and expenses. They don’t match services provided to the value of those services. The average elapse time between work performed and collection of payment for that work is 138 days, more than 4½ months. The largest asset of most law firms is the investment in uncollected fees and expenses.
Half way between full accrual and the cash method is the as-billed method. The as-billed method is simpler for the law firm to implement and administer than full accrual, but is still far superior to the cash method. From a practical standpoint, the as-billed method has a lot to recommend it. All operating expenses are recorded on a full accrual method and unbilled expenses incurred on behalf of clients (hard cost) are, also, booked on an accrual basis. Fee revenue is recorded as billed. Thus, under the as-billed method, the only thing left off the books is Work in Process, i.e., unbilled fees and unbilled soft cost billable to clients. For external statements, the firm will still want to include Work in Process, less a reserve, to adjust those worked, but unbilled, services to the value that the firm expects to ultimately realize.
The proof that accrual is the appropriate view from a management standpoint becomes clear anytime you start to compute the key pieces of information that a firm must understand in order to manage their firm and plan for the future. When you look at the cost per associate to determine break-even point, or profitability per associate, you have to think on an accrual level. If you advance to the issue of matter or case style profitability, you have to think on an accrual level. The importance of the accrual view doesn’t mean that understanding the cash side isn’t important. You can’t realistically forecast cash without starting from the accrual view. For example, on average it takes 78 days for work performed to get billed and another 60 days on average to collect those fees. So to project cash you have to think accrual. It doesn’t work in reverse.
Change to the accrual method and what follows, of course, is that you begin to start thinking about changing things. Why does it take 78 days to get work billed? Why are our clients taking 60 days to pay us? What can we do to reduce the number of days, etc.?
Accrual brings it all together and you can start thinking of your law practice as the business that it is.
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Filed under Management by Tom Collins