Law firms are businesses, and all businesses rely on money to survive. Retail sales executives know all about sales conversion and managers eagerly track the metrics of a cash conversion cycle, but this may not apply directly to law firms.
Legal practitioners, especially those in solo practice, do not have the luxury of dedicated administrative, accounting and management staff. The legal practitioner becomes self-reliant and must have a working knowledge of a wide range of management concepts to keep the boat of business afloat. Understanding which metrics are important and where to find them, provides guidance in otherwise murky financial water.
In addition, professional staff are often remunerated on their productivity: Fees.
Accounting terminology
As law firms do not retail in commodity, some of the typical management accounting terminology used by legal practitioners appears ‘strange’ in the professional services environment. Traditional accounting tools have to be adapted to fit a legal practitioner’s/law firm’s specific need.
The term ‘sales’ does not fit well. A legal practitioner’s professional time is sold to clients as ‘professional fees’ regardless of whether this is billed by the hour or minute or based on a tariff. The value of this professional billing rate represents the market value of the services. It is primarily defined internally. In addition, ‘fees’ are not ‘sold’ to faceless customers. Fees are billed to clients in a confidential, privileged relationship with the firm. Fees are billed to a client (debit) and credited to an income or revenue account.
For a legal practitioner’s purpose, a fee is a revenue item, debited to a client and credited to an income statement account.
Disbursements are value added cost items, which are both incurred on behalf of, and recovered from clients. This often includes items such as travel or photocopies. There is no direct relationship between the cost item and the client debit, and a portion of the total value is discretionary.
Disbursements, insofar as they are discretionary and contain an arbitrary, value-added component are simply fees.
Reimbursements are direct cost items, which are both incurred on behalf of, and recovered from clients. There is a direct relationship between the cost item and the client debit, and the total value is invoice based.
Reimbursements are cost items that are invoiced directly with no arbitrary or value-added component. These should be separated from fees and for a legal practitioner’s purposes may be journalised as a debit to a client and a credit to a creditor’s account.
A client account may reflect any combination or none of these. Client business debit balances represent a legal practitioner’s accounts receivable, or debtors’ book (an asset). This is what is owing to the firm. It must not be confused with the value of the capital involved in debt collecting matters.
Note that ‘fees’ represent a book entry against a client (current asset, a debit) and a revenue account (income, a credit). It is not yet cash, it merely represents the value of work done. Only once payment is received the value moves from the debtors’ book to the business cash book, which is also an asset. One can spend cash from the cash book, but one cannot spend the balance of the debtors’ book. This makes it imperative to understand the values of the debtors’ book and cash book, as well as the conversion rate of fees to cash.
Contingency fees do not form part of this discussion
Fees written represents the income account balance of work done but is not tracked across the debtors’ book or cash book, which means that there is no control over the conversion of those fees to cash.
A simple, high-level tool to measure productivity is a fee to cash report. For a given period one can calculate the total nett fees generated by a specific fee earner. Nett fees include fees, any discounts or reversals, and value added tax (VAT), if applicable. Discounts amount to ‘fee reversals’ and will not be recovered from the client and must reduce the firm’s revenue.
An age analysis gives an easy breakdown of who owes what, and for how long. An age analysis should show as much detail as possible, with each individual matter listed and a breakdown of outstanding balances for at least current, 30 days, 60 days, 90 days and 120 days and older. Older debt should be aggressively managed. A best-fit solution should clearly distinguish contingency fee matters.
Movement on the debtors book for the period is critical. Fees and recoverable fees charged to client accounts increase the debtors’ book. There are at least three outcomes, namely:
This clearly indicates that generating fees alone does not equate to cash. In addition, it reveals the relevance of monitoring fees to cash conversion, as it indicates the cash quality of clients. Remunerating staff based on fees written is a common, but dangerous premise as it may rapidly deplete available cash reserves while income is not rapidly converted to cash.
The brief example (table 1) is designed to explain the discussion. The following metrics are used: Three fee earners, with all matters assigned to one of these three, a defined date overview, total fees in overview, debtors book movement in overview.
On John’s matters fees were charged to the value of R 100 000. The movement on the debtors’ book is only R 10 000, which indicates that most of John’s clients settled their accounts in the period under review. The movement is deducted from the fee total. John’s fees to cash conversion rate is 90%, which shows that John’s fees to cash is R 90 000.
On Peter’s matters fees were charged to the value of R 120 000. The movement on the debtors’ book is R 90 000, which indicates that most of Peter’s clients did not settle their accounts in the period under review. The movement is deducted from the fee total. Peter’s fees to cash conversion rate is only 25%, which shows that Peter’s fees to cash is R 30 000.
On Frank’s matters, fees were charged to the value of R 90 000. The movement on the debtors’ book is R 120 000, which indicates that in the period under review –
The movement is deducted from the fee total. Frank’s fees to cash conversion rate is a negative 33%, which shows that Frank’s fees to cash is a negative R 30 000. Frank is costing the firm money.
From a management point of view, a report such a this is merely one of several tools to be used. Additional reports such as budgets, forecasts and age analysis should be added to provide a more holistic view of the firm and its operations. Fee targets may be added to this example – the value of which – should at least cover fixed salaries or drawings and a commission rate calculation. Especially with professional remuneration based on a fixed salary, targets should at least cover the fixed remuneration component and commission can then be calculated on the fees to cash value. Multiple fee targets, covering overlapping time periods will go a long way to protecting the firm against manipulation and abuse.
Working from a high-level fees to cash model such as this, it is possible to customise and personalise an individual remuneration model for any firm. As illustrated, fees to cash protects the firm from pay-outs where cash has not been realised.
In our example, if Peter had a fee target of R 100 000, he has made target, which entitles him to commission. A commission rate of 17% on fees to cash results in a pay-out of R 5 100.
A discussion such as this, attempts to simplify a specific concept. It must be seen in the context of management accounting with the emphasis on operational success and cash flow management. ‘Fees written’ is simplistic as a productivity measurement metric and proactive management of the debtors’ book is essential. Simple, easy to use tools are to be preferred, but these should be accurate and contribute to our understanding of the problem at hand. Overly simplistic solutions, such remuneration based on fees written pose dangers to the survival of the business.
Carl Holliday BProc LLB (NWU) is a non-practising legal practitioner in Pretoria.
This article was first published in De Rebus in 2019 (Aug) DR 12.
