Accounts receivable: Cash flow analysis

September 1st, 2020
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Cash is the lifeblood of business. Accounts receivable refers to the unpaid accounts for work done by the law firm. An analysis of the composition of these accounts reveals profound insights into the financial health of the practice.

Depending on the nature of an attorney’s practice, the composition of individual accounts receivable can vary greatly. Often a good mix of disbursements and fees occur on a single account, but an account composed exclusively of fees is also possible. Advocate accounts are simple in this regard: Fees only, no disbursements.

Management accounting is quick to provide guidelines concerning the tracking of financial performance, with the emphasis on average invoice values, reducing debtor days (which deals with clients, not proceedings dealing with s 65 of the Magistrates’ Courts Act 32 of 1944) etcetera. Most of this advice ignores a simple yet powerful truth, which is, unlike an advocate, an attorney by definition is an agent, working simultaneously for own account and covering costs on behalf of a client. An attorney’s practice is largely unique in the world of management accounting and failure to appreciate this fundamental difference, flaws many management models, financial reporting systems and cash flow management techniques.

Identifying disbursements

A disbursement has two unique identifying characteristics:

  • First, it is defined by a source document. A disbursement is invariably paper based and there will always be an invoice from which the amount can be verified.
  • The second defining characteristic is the cash flow incurred: The attorney is invariably out-of-pocket for the value of the disbursement, and any payment received only constitutes a refund.
The arbitrary nature of fees and spes (an expectation) of payment

A professional fee, on the other hand, is an arbitrary value placed on work done, where payment is subject to negotiation, and typically still at a future date. At the time a fee is charged to an account, no payment has been received, but a hope of payment is created with the client, a mere spes. In a certain sense, the fee has not cost the firm, and any cash flow implication is at a future date. If a discount is given, an attorney merely reduces their hope of future payment, they do not suffer any immediate cash flow implications.

Common items charged to client accounts are often considered disbursements, when these are in fact fees. Consider a charge for travel: Where an invoice is available for travel, this should be recovered directly as a disbursement. Where the value of the travel is arbitrary, such as an attorney who drives their own vehicle, the appropriate charge is as a fee for travel time. The value of this travel is subjective and arbitrary. Since there is no underlying invoice on which to found the cost of the travel, this must of necessity be a fee. However, in the event of air travel or using a ride hailing service, such as Uber, there is always a source document as proof of the value, and nature of the disbursement. The invoice is not arbitrary. The same applies to photocopies: Where an invoice exists from a third party printing company, this is recoverable as a disbursement, if no invoice exists, the charge for producing photocopies is arbitrary and raised as a fee. Expenses such as fuel, rent, salaries etcetera cannot be directly recovered from any client as a disbursement. Any item not invoice based and recovered from a client forms part of the service rendered and constitutes a fee, subject to VAT.

Failure to distinguish fees and disbursement have serious implications for determining profitability and general financial success.

For example, an attorney charges R 400 for professional services.

On invoice one an additional R 100 for a common disbursement, such as service by the Sheriff, is reflected. On receiving payment, the turnover on the account amounts to R 500. The R 100 disbursement constitutes only a refund, while the fees amount to R 400.

On invoice two, however, the disbursement amounts to R 1 600. The turnover on the account amounts to R 2 000, with fees remaining at only R 400.

Confusing disbursements with fees ignores the refund nature of the disbursement, and undermines the profitability of the firm. Partially the problem starts with the terminology employed. Referring to any charge raised against a client account as a ‘fee’ does not provide clarity as to the nature of the transaction. A fee should only be charged for work done. Disbursements reflected, should be clearly identified by direct payments, such as electronic fund transfers or cheque payments from trust or business accounts, or by an agent’s journals where a business journal entry is used to debit the client and credit the creditor. The Sheriff may indeed charge a fee in his books for the service required, but in an attorney’s books, the Sheriff’s charge is not a fee, but a disbursement. The use of clear, unambiguous terminology, supported by accurate transaction processing that enforces this model will provide greater clarity as to the nature of charges raised and the attorney’s potential cash flow implications.

There is a hidden danger in a low fee transfer environment. For the majority of Value Added Tax (VAT) vendors, VAT becomes payable as soon as an invoice has been issued, regardless of when payment is received. This, of necessity, implies that VAT payments to the South African Revenue Service would have to take place before the fee revenue is realised, exacerbating an already precarious cash flow crisis.

Spending cash is only derived from fees. Where expenses exceed fee revenue, it would become impossible to cover all obligations. Profit is derived from fee revenue, less expenses.

Trust transfer analysed

Based on a proper understanding of the nature of fees and disbursements, a clear picture may be formed of the nature of current and future cash flow analysis. An attorney’s custom accounting solution provides fast, accurate trust to business transfer mechanisms, to balance client business and trust ledgers. These transfer functions allow ledger entries on multiple accounts and a single interbank account transaction (compare accounting r 54.14.12 from the Final rules as per ss 95(1), 95(3) and 109(2) of the Legal Practice Act 28 of 2014), reducing the risk of processing errors and bank charges. To continue the examples above, the disbursement portion of a trust transfer are not available as cash, the very refund nature implies that an attorney has not earned new cash, but has merely been repaid that what was formerly spent. The fee portion of the transfer is not a refund, but constitutes free, available cash. This free cash is what is applied to cover expenses: Rent, salaries, Internet etcetera. Where the fee revenue falls below the budgeted expenses, some expenses must remain unpaid. Whereas disbursements merely imply a refund, fee revenue is applied towards expenses. Expenses reduces a firm’s profit, and are not directly recoverable from a client.

In addition, where professional remuneration is based on revenue derived from fees, this confusion erodes the firm’s profits. Consider remuneration calculated on invoice two above: Calculating remuneration on turnover of R 2 000 implies that the cash value of R 1 600 refunded, will be applied towards remuneration. This means that cash, which is effectively unavailable, is applied towards paying the salary expense. Not only is the firm out-of-pocket for the value of the disbursement, this value is now allocated to an expense. Imagine the disappointment and confusion after signing off on a major trust to business transfer and realising the expected cash is not available in the account.

Money, which does not exist, cannot be paid out.

Any sophisticated attorney’s accounting system should provide for a clear breakdown of fees and disbursements on a transaction level. It should also be able to analyse a trust to business transfer to indicate the individual ledger accounts involved and the individually separate and distinct amounts transferred as either fees or disbursements. Additional management reports, identifying those accounts subject to disbursement transfers and a breakdown of cash flow down to expense level should be expected.

Cash flow analysis should start with individually separate and distinct transaction processing, followed by accurate trust to business transfer analysis, to separate fee revenue from disbursement refund. The analysis should continue to allocate available cash to budgeted expenses and finally determining profit.

Carl Holliday BProc LLB (NWU) is a non-practising legal practitioner in Pretoria.

This article was first published in De Rebus in 2020 (Sept) DR 10.