Tuesday, July 31, 2007

Law firm AR Management gets easier

For many US based law firms with a December 31 year-end, the summer months represent the “quiet before the storm”. Once Labor Day rolls around, those firms will be ratcheting up their collection efforts to meet year-end targets. However, this practice may be short lived. As I have said in the past, there are only three main reasons why clients don’t pay their legal bills: relationship issues, billing issue and economic issues. Well over the past two years something is changing in the profession that, I feel, will alleviate some of the ‘relationship’ issues.

The thing that is changing is how firms bill for work. Law firms like all professional firms sell knowledge or expertise. This is quantified by the sale of hour or part thereof. For the longest time, I questioned the hour as the unit of sale, reason being it doesn’t make counsel more efficient and it is prone to ‘padding’. The practice of law, depending on the area, either has engagements with a definitive outcome or a probabilistic outcome. Therefore, it is a progressive firm that can use this knowledge to their advantage. As an example, a firm is faced with a particular engagement. They have a very good idea of what is involved in completing the engagement. They know who will work on the file, the related costs and the probability of success. Therefore, they can approximate a fee for the entire engagement. This now provides the firm with two powerful benefits: a negotiating tool in a competitive environment, and timely collections.

How does fixed fee billing speed up collections should be the question that comes to mind. Fixed fee billing removes the variability from the client’s wallet. The client knows going in to the engagement what it will cost and the probability of their desired outcome. With fixed fee billing, the client buys a pound of sugar and gets a pound of sugar – no surprises. Unlike the hourly basis, they buy a pound of sugar and can end up with 6 grains of sugar!

This may seem like ‘pie-in-the-sky’ as most firms can’t even get themselves to the point of deciding if particular clients are profitable or not. In fact, fixed fee billing is fast approaching reality. About 18 months ago articles started appearing where small firms had given up the classical hourly billing in favor of fixed fee billing. Their initial motivation was to get away from the huge administrative task of billing. Over the past year the momentum has picked up and of late, medium and larger firms are embracing fixed fee billing. In a recent article on Law.com, a few large national firms have adopted fixed fee billing for specific practice groups.

Some of the feedback, in the literature, on fixed fee billing is astonishing! After operating in a fixed fee mode for twelve months or more, many firms report a huge drop in the amount of AR they have and WIP becomes more “manageable”. A few firms have said “…we have no accounts receivable!”.

I feel the time is right for firms to move to a fixed fee or probabilistic fee billing model. Firms will gain greater competitive advantage as they will work toward minimizing costs through increased staff efficiencies and in so doing achieve their desired profitability. These firms will take on work that provides them the required Return on Investment while doing good work for the right clients. Those who pay timely!

Monday, July 16, 2007

Successful Collections, a team sport?

In one of my earlier writings I made the point of paradigm shift; the need to make that quantum leap into a different way of thinking and doing business. This, I feel is, essential to cast off the bondage of old ways of doing things. I have noticed that all too often, most businesses continue in a lock-step of their past. Although they achieve success, the success isn’t near what they could possibly achieve. Over the past few weeks I have met many people who practice the concept of truly thinking out of the box. These people have developed such a skill they have become consultants to multi-national and global companies.

If you have experienced even one of my seminars on collections you will know that accounts receivable delinquency dates back to 1500 BC. One would think that over the last 3000 + years we would have rationalized AR collections to a science. However, that hasn’t been the case. It hasn’t, simply because AR collections is a people process, we must work through with other people to get what we want; our bills paid. With that said, I am sure we can draw knowledge and insight from other facets of industry.

The human phylogenic roots orignated about 6 million years ago. As one traces the evolution to modern day humans, it becomes very clear that human beings are communal animals. Our entire survival rest in our ability to be part of a group, tremendous research has been done on group behavior. It was found that the optimal group for humans to be part of is 75 individuals. It was found that groups of 75 individuals function the best, when the size of the group exceeds 100 individuals the group breaks apart in to smaller groups. It has been postulated that human survival requires being part of a group. What can we learn from that? One must ask the question, why? I have reasoned that groups of 75 provide both enough diversity in skill and the ‘right’ degree of formality. To play on the skill aspect, each person in the group brings a certain skill to the group, which enhances its probability of survival – team work!

Let’s apply this to the typical professional service practice, with its diversity of skill. The collector is a responsible member of the team bringing their unique skill set for the betterment of the overall team. Their role is to work with the client to get the bills paid. These are the same bills that the billing attorney instructed the billing specialist to create. The file was probably brought in by the responsible partner and the work was managed by the supervising attorney. Is the picture beginning to unfold? Each person in the firm injects their expertise to ensure the entire operation not only runs smoothly, but is successful.

Success is a relative term. What defines success for one person could be considered failure for another. However, if we contend that the law firm’s definition of success is to provide outstanding legal services and earn a profitable return on investment then we have succeeded. We can see that everyone on the team plays a vital role and is responsible for their part in the ‘successes of the firm. Taking this a step further, if profitability is tied to success then everyone should support the expertise of the collector in getting bills paid. That assistance provided to the collector must start at the very beginning of the attorney client relationship, at the initial meeting. It is the attorney’s responsibility to set the stage of how the relationship will progress, how services will be rendered and when payments are expected. All too often, I don’t feel this happens – sadly enough.

Over the last few weeks I witnessed true team work in action! Lately I attended many conferences and conventions and I watched how the wait staff took care of upwards of 2500 people. During one such conference a waiter talked about a recent conference of 8,000 people. Think of it, feeding 8,000 people. Every meal is perfect down to the temperature and the presentation. Now that is team work!

Recently I had the opportunity to dine at Maggiano's, an upscale Italian restaurant in Las Vegas. During my meal selection process I was approached by Michael Pawlowski, the Executive Sous Chef, who took tremendous time in ensuring that every question from the group was answered. Throughout the meal, Mike stopped by regularly to check on the group. Through discussion we found out that the restaurant serves upwards of 400 people per day and that doesn’t even consider their entire catering business. One would think that kind of pressure would be the seed for chaos. However, Mike spoke of how the entire process moves in lock-step to the challenges. In a rare act, Mike took our party for a tour of his kitchen and sure enough, his staff of 20 focused and synchronized to the fulfillment of their goal, their success; making sure each order was perfect!

I think it is time that the concept of teamwork becomes emblazoned in the hearts and minds of today’s professional practices. Each one of the players must not only understand, but feel, how the actions of others impact what must be done for the success of the team. If the goal of the firm is profitability, one must ask oneself, “How does what I do help the team achieve our goal AND what can I do to help my team members achieve their part of our overall goal!


Tuesday, July 10, 2007

Whipping Value into WIP

My recent posting, Taxation, the best Collections Motivator, brought plethora of responses. I heard everything from: uh....say what, to wow, interesting perspective. For all of those who took the time to share their feelings, thank you. I appreciate your feedback. One of the responses was the seed to this week’s entry. As countries enter the global marketplace they must adopt a more global perspective, once such adoption is maintaining their financial records in accordance to the precedents of the International Accounting Standards Board (IASB). Some of the hot topics now are the valuation of inventory and the recognition of revenue. A few weeks ago, I was fortunate enough to be part of a symposium on some of the IASB standards that will be hitting US companies in the next 3 years. It was the question of a reader asking about WIP valuation that catapulted me back to the symposium and got me thinking about WIP valuation in legal practices.

After considerable difficult research, as little information is published about professional services, I came to the conclusion that: Today’s law firms are valuing WIP wrong! One of the things I learned early in my finance career is some things can be classified as right or wrong, other things come down to presentation. The errors in our ways come from the simple act of recording work-in-progress at the selling price. If we look at the very basics in accounting.

Work-in-Progress in professional services is nothing more than inventory, inventory no different than at Ford Motor Company. The basis of inventory valuation is at cost. Now there is a whole discussion to be had about LIFO and FIFO. But regardless, valuation must be at cost. Taking this a step further, it must be the current cost of production, which in itself includes fix and variable costs. It is on this basis that commercial entities have the line item on their P&L of, cost of goods sold. At the same time, professional services should also have the line item, cost of services provided. But they don’t! The professional services P&L and balance sheet, for that matter, is essentially a mish-mash of incorrectly categorized items.

On a very basic level, firms record the selling price of fees in work in progress, while, at the same time, they record disbursements at current cost. This, by its very nature makes WIP valuation a hash total of figures. Then to top it off, firms expense all of the overhead costs of providing the services. Whether or not you maintain WIP on the balance sheet, their whole concept of getting a true value of work-in-progress and accounts receivable is truly a hit-and-miss undertaking. The firm’s largest current asset and it can’t be accurately valued!

How do we pull order into this disarray? I am not professing order for the sake of order nor for alignment with current or future accounting standards. I believe that firms need to have a strong handle on the valuation of their largest current asset, then and only then can they truly manage it.


To illustrate using a simple example, John is a sole practitioner who employs a secretary, Mary, who has paralegal skills. They have a very small practice outside of the big city where the rent is $500 per month; half of which is for administration. The firm out-sources all of their searches and IT, the costs for all is $700 per month; half of which is for administration. On the compensation side, Mary earns $24,000 per year and John has an annual draw of $60,000 per year. Their billable rates are: Mary $30 per hour and John $75 per hour. Furthermore, they have jointly agreed to work no more than 2,000 hours per year. Based on where they are located there are no additional payroll costs. On June 1, they secure a client which will take all of their time; they plan to bill June time on July 15th.

Under this model on June 30th, the value of work-in-progress is $7,420, comprised of $6,720 in fees (at cost) and $700 in fixed costs. Then at time of billing, July 15th, the value of the accounts receivable is $17,500, comprised of $16,800 in fees and $700 in flow through costs along with cost of services provided of $7,420 and a straight P&L hit of $700 for administration expenses. While in today’s firm on June 30th, we would see $16,800 in WIP fees, $1,200 in expenses and $4,800 in payroll costs. Then on July 15th we would see $16,800 in billings and AR with all costs hitting the P&L.

One could argue that the proposed scenario and current practice are essentially the same, in that we neither created nor lose cash. In reality, the difference comes down to timing and presentation. However, under the proposed model, at any point in time the firm has a very accurate valuation of their work-in-progress, there is better matching of revenue and expenses and not to mention increased accuracy in determining profitability. Because now, we have costs of services provided, which can be broken down by department, practice group, area of law and…. by partner! This practice would empower firms to be better able to quote work, knowing well in advance what their gross margin on such work should be in order to meet the goals of the firm.

Overall, the resulting balance sheet and P&L are in GAAP compliance!

Tuesday, July 03, 2007

Taxation, the best Collections Motivator

For the last several weeks I have focused on some of the nuances of collections and more specifically collections in law firms. Being on the road for the past several weeks has brought on the homesick bug and therefore, I thought this week’s contribution should be back to the basics; of accounting.

I can almost guarantee that if I were to ask a randomly selected group of people how much they embrace their tax system, their answer would be far from endearing, such words as detest and hate would fill the response. Why has taxation gotten such a bad rap? It was probably because of that famous slogan of the mid 1700’s; “no taxation without representation”. Whatever the reason, taxation is a good thing and it is good for many reasons. First, it means you have earned enough to not only survive but enough to repatriate, it keeps accountants employed and in Europe it stimulates collections! Why should anything that bears such benefit, be black listed? To gain a real appreciation for the importance of taxation on collections we need to have an appreciation of accounting, and then look at what European and other countries are doing.

The 1494 writings of Luca Pacioli had a greatest impact on the financial world. It was his writing, Particularis de Computis et Scripturis, a treatise on accounting that made Pacioli the Father of Modern Accounting. Pacioli established the basis of double entry bookkeeping and many of the structures of modern day financial record keeping. Today, accounting is one of the most vital organs in the commerce. Historians argue about what seeded the need for accounting, some argue that accounting was developed purely in response to the needs of the time brought about by changes in the environment and societal demands. Others claim that the development of the science of accounting has itself driven the evolution of commerce. It was only through the use of more precise accounting methods that modern business was able to grow, flourish and respond to the needs of its owners and the public. Either way, the history of accounting throws a light on economic and business history, and may help us better predict what is on the horizon as the pace of global business evolution escalates. Regardless of its origin, it is the basis of every tax system and it is here to stay!

For almost all US based law firms, cash-basis accounting is the mainstay. It is the way accounts have been managed since the first firm began, and the practice continues today. It is the very basis of maintaining the firm’s accounts on a cash-basis that creates the ‘year-end crunch’. This, however, isn’t the case in the rest of the world. In almost every country, professional services must run on the accrual basis. Accrual accounting redefines law firm revenue and profitability.

Cash accounting only recognizes revenue when cash is actually deposited, while accrual accounting recognizes revenue at the time of bill creation. What a motivator! Just that simple change of when to recognize revenue triggers a whole host of tax implications. Hence the motivation to collect! Who would want to pay tax on money they didn’t collect?

In December 1997, European Countries withdrew the practice of cash-basis accounting for computing taxable profits for professional services organizations in favor of a ‘true and fair’ approach’; accrual accounting basis. With the ‘go-live’ date in 1998, there was considerable upheaval in the legal community. Here were a group of professionals who had to radically change how they managed their organizations. They had to cast away the shackles of the mad year-end crunch for a more consistent approach of receivable management. Otherwise, they faced the penalty of the tax-man! Amongst the hostilities, there were many hidden benefits that today’s US law firms don’t see. European and other law firms around the world, have considerably lower average days to collect, better utilization of assets, better cash flow management and comparatively smaller operating lines of credit.

Let’s now fast forward and really make collections the forefront! On March 10, 2005, the Accounting Standards Board (UK) issued UITF Abstract 40. This circular plowed full force into uncharted territory in the professional services arena; revenue recognition and valuation of work in progress. Although a mainstay of manufacturing organizations, this was very new for professional services, and as such met with tremendous resistance. To the professional services firm… now revenue will be recognized when the work is done!

Once the accounting community worked out all the pieces; sure as anything the tax department jumped on the band wagon! With all the hoops and loops to be dealt with, the European tax authorities put in a plan for firms to take all of the work in progress into income; over time. Otherwise, firms with three months billings in WIP would recognize 125% uptake in revenue – straight to the bottom line! The end result of all of this… the inception of new accounting rules lead to progressive tax rules, which ultimately benefited the firm, bill faster and collect faster!

If it wasn’t for progressive accounting and taxation, would firms ever bill or collect?

Hooray for Taxation !!!