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!

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