Warning: The article below contains 30 seconds of material about accounting. Please power through and do not tune out.
In 1987 I was admitted as a partner to my mid-sized law firm. (At the time, I thought that being a partner in a law firm was a good thing.)
Back then, the firm was a suburban firm which did a great many residential real estate transactions. The thing about residential real estate in Toronto is that everyone wants to move in the summer when there is no snow on the ground. So, the summer was a remarkably busy time, and that left no time for sending out reporting letters or bills. In September and October when the rush was over the bills would start going out and money would be transferred from the trust account, and by November and December the rest of the money would start coming in.
Apart from the residential real estate issue, the lawyers in every area of practice used to focus primarily on getting the work done, and only secondarily on sending out bills. Many bills only went out when the managing partner started cracking the whip on getting the WIP out in the last quarter.
Finally, there would be a big rush to bill all files in December so that the fees would be counted toward each individual partner’s compensation numbers. This left no work in process to bill in January and just a bit in February, so the first quarter was always awful.
As a new partner, I mistakenly assumed that the senior partners knew what they were doing. With my education in accounting limited to “Accounting 101”, I did not understand that they did not. I certainly did not understand that they were doing “cash accounting” and only looking at cash flow to determine whether or not the firm was making any money.
So, in each of the first three monthly partners meetings, when all the older and wiser partners appeared to be very concerned that we were not making any money, I also became genuinely concerned.
Around that time my car quit on me. I needed a decent sized vehicle, and I needed it quickly, so I bought a K car which was one of the least expensive sedans available at the time. For those of you who do not know what a K car looked like, suffice to say that back in the day, when your lawyer drove up in a K car, you would have to wonder if he or she was any good at their job. For those of you who do know what a K car was, you can stop laughing now. (Note: The picture above is not a picture of a K car. The car above looks more like a vehicle for a professional than a K car.)
In any event, the next 6 partners meetings only confirmed to me just how wise I had been to conserve my cash by buying an inexpensive vehicle, what with all the discussions about how we were going bankrupt and might have to make a cash call on the partners.
Of course, in the last quarter the cash started pouring in, as had apparently happened in exactly the same way for many years, just as the partners had agonized over their financial position in exactly the same way for many years. The firm made record profits that year, but I still owned a K car.
As you can imagine, for nine months of every year the frightened partners had made management decisions on the basis that bankruptcy was imminent. For example, we had deferred hiring, salary increases, and even much needed equipment purchases.
Since the good old days, sophisticated law firms have figured out that work in process must be billed currently. For one thing, if you want to have positive cash flow, bills must go out on a timely basis. For another, it is well known that clients are more willing to pay legal bills when they can still remember and appreciate the work that was done.
However, it is still in the nature of some lawyers to defer getting their accounts out for various reasons. Sometimes, they are too busy with billable matters to address “administrative” tasks. Other times they procrastinate in deciding to write down or write off time hoping (usually in vain) that “later” will be a better time to bill the full amount.
Despite all the reasons that lawyers can come up with to get this wrong, one thing that should be manifestly clear is that accounting for work in process is one of the most basic and crucial accounting steps that a law firm should take. If you do not understand the value of your work in process, you cannot understand your profitability at any given time or make sound business decisions based on your financial position.
In Canada, the tax laws have changed in the last few years so that professional firms must recognize their work in process for tax purposes. (Of course, it is not as simple as all that, but the statement is accurate enough for the purpose of this article.) But, having to come up with a number at the end of the year for tax purposes (which number you want to be as low as possible) is not the same thing as really understanding and managing your work in process. Really understanding and managing your work in process means:
- Knowing which work in process is billable and which is not;
- Understanding which work in process is collectible and which is not;
- Recognizing write off patterns to determine which type of work is profitable and which is not; and
- Using the information to:
- determine your cost of providing services;
- evaluate the efficiency of lawyers and law clerks;
- identify where training or technology might be of assistance; and
- consider whether career paths should be redirected.
I mentioned in a previous article that in 1997 the “old guard” left our firm and the younger partner group, recognizing our lack of management experience, eagerly sought out professional assistance.
To that end, we retained the retired managing partner of a branch of a national accounting firm on a part-time basis to head up our accounting department. Putting work in process on our financial statements was one of the very first things that he recommended to us, and suddenly a whole new world of proper budgeting and planning opened to us.
Of course, as with everything else, lawyers sometimes use their advocacy skills to work around any rules that the firm may impose about work in process.
The prevailing wisdom is that work in process is most valuable immediately after being created and should be billed when fresh. Despite this, I have seen lawyers twist themselves in knots arguing why certain work in process will be worth more if allowed to age like fine wine. I have also seen lawyers argue why their own work in process on a file is “hard” but the work in process of other lawyers, clerks and students on the same file is “soft” and should be written down. And of course, there is the classic story of lawyers who when leaving a firm suddenly realize that the work in process on files that are leaving the firm with them actually has extraordinarily little value.
The bottom line is simple. In order to manage a firm or just an individual practice, you must understand your work in process. Failure to do so may result in you having to drive today’s version of a K car, and as I found out firsthand, your partners will find it hilarious to mock you for that.
Dedicated to Drew Pallett, who laughed the loudest.