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Law firm partners and administrators face an economy that may challenge the assumptions supporting the revenue projections in their 2001 budgets. In this uncertain environment, financial management (from the controller to the chief financial officer) needs to keep partners focused on revenue growth, while management also considers cost reductions to improve cash-basis profitability. One cost a law firm should not skimp on is its investment in financial management talent. Law firms have made significant improvements in business management during the last 10 years. However, many firms remain hesitant to upgrade their financial management talent, and that could be holding down profitability. Strong financial managers will pay for themselves by improving internal controls, operating procedures, fiscal management, and even practice management. INTERNAL CONTROLS According to Credit & Collection Manager’s Letter (September 2000), it is estimated that fraud in the United States costs businesses between 2 percent and 6 percent of gross profits annually. Potentially fraudulent activity in a law firm might include fraud schemes involving cash, accounts receivable, purchasing, payroll, or expense accounts. Good financial managers should establish a strong internal control process in the day-to-day operations. This internal control process will include both preventive controls and detective controls. Preventive controls are proactive controls designed to avoid an unintended event or result. Detective controls are reactive controls designed to discover an unintended event or result. Many law firm financial managers fall into the trap of relying too heavily on preventive controls, and give much lower priority to detective controls. But not having effective detective controls will increase the risk of irregularities. It will also increase the time, effort, and costs to investigate and resolve any reconciling transactions at a later date. One example of a detective control is an effective bank account reconciliation that is completed when the bank statement is received. The reconciliation process should include reviewing canceled checks and reconciling every item recorded on the bank statement and in the general ledger. It might be tempting to delay or skip certain control procedures because you believe that you have honest and trustworthy employees. But remember, in most cases of fraud there is an element of trust that allowed the employee the opportunity. As the old saying goes, “Good controls keep honest people honest.” A good financial manager will be mindful of the value of a strong internal control process. OPERATING PROCEDURES While fraud attracts more public attention, a hidden cost that may result in even greater losses is ineffective operating procedures. For instance, it is not surprising for us to hear from a managing partner that, after investing a significant amount of money implementing a new practice management software system, he or she still receives the same information as always, and operating procedures have changed very little. Strong financial managers should be eager to create changes in operating procedures in order to continue improving the productivity of the accounting department. In fact, new software and related technologies almost require that you re-engineer your accounting procedures; otherwise, the value buried in your technology investment will not be realized. Many law firm partners request routine accounting data from their accounting personnel in different formats. Some requests may be client-driven. Other requests may simply be a partner’s personal preference. The end result may be that 99 percent of the required information is available in one simple report, yet acquiring the additional 1 percent may take twice as much administrative effort. The weakest link in this process is that the partner rarely knows the overhead cost required to complete the special request, and financial managers rarely communicate those costs to the partners. We often hear, “That’s the way it has always been done” or “The partners want it that way.” There can be tremendous hesitation to even consider whether a change should be contemplated. Strong financial managers must be charged with tackling these operational issues and dramatically improving administrative efficiencies. Processes must be re-engineered to take advantage of enhancements in automation. Just as important, financial managers need to initiate the discussion of inefficient processes that are perceived to be important to partners. All too often, the partners will quickly accept reporting or operating changes when they understand the hidden administrative costs that are being expended to serve their particular requests. FISCAL MANAGEMENT The challenge with fiscal management comes from accurately reporting and analyzing financial and operational information in a timely manner. A law firm can get by with an effective bookkeeper, but as the practice grows, the value of a professional financial manager skyrockets. For example, it takes a couple of months for some firms to complete their budget preparation process. Information is gathered from a variety of sources to estimate the demand for billable work, timing of collections, and expenses. Then, before the ink is dry, the economy changes. You do not have another two months to wait for updates. You need updated projections quickly. The analysis of financial results will include both cash-basis and accrual-basis concepts. Management needs to know that the financial analysis includes timing matters related simply to collections and disbursements, as well as operating variances such as whether the value of time worked continues to support the level of costs you are incurring. A good financial manager should be able to quickly accomplish your fiscal reporting needs. Cash management in a law firm goes hand-in-hand with overall fiscal management. Partners face a unique situation every year that salaried employees do not face: How much money will I make this year? When will I be paid? The lack of effective cash management will cost a firm in lost interest earnings or excessive interest expenses, but more important, it will lead to taxable income and cash distribution surprises for the partners. In addition to appropriate cash management and partner reporting, financial managers should improve the speed of billings and collections. Fiscal management also involves the analysis of profitability. Should the analysis include practice area or other breakdowns of profitability? How should indirect expenses be allocated? Who should receive profitability information? What is the purpose of the profitability report that is being generated? Do reports disclose pertinent information that a report user should understand to make informed decisions? These are some of the issues to consider with profitability information, and these questions are apart from the actual evaluation of the results. Effective financial managers will reduce the time typically spent by partners and other senior management to locate important trends and variances that might be hidden in pages of financial reports. PRACTICE MANAGEMENT Financial managers may not play a role in the legal work the firm performs, but the financial data they can provide regarding practice management should not be overlooked. For example, accounting staffs are being used to assist with engagement budget preparation. After all, a budget or projection of your legal engagement is essentially a cost accounting estimate of the effort required to complete the assignment. Historical information about similar engagements can be evaluated to assist in developing reasonable hourly estimates for planning discussions with clients. Alternative-fee requests are another area where strong financial managers can play an active role in improving a firm’s financial performance. For example, a few months ago, a Texas attorney inquired about any studies or data regarding the benefits for a law firm and a client regarding the use of Web-enabling collaborative software. The assumption was that the collaborative effort would allow the law firm to be more efficient in its client representation. However, the firm would not want to bear the entire financial burden while billing at traditional rates because the firm would be assuming all the financial risks of the new arrangement, while the benefits would reduce client costs and reduce the firm’s profits. Analysis showed that a shared arrangement would be necessary to get this engagement off the ground. Financial managers can also be valuable in support of practice management decisions regarding issues such as: � Should we merge? � Should we have an international presence? � Should we expand to other U.S. markets? � Should we expand the diversity of practice areas? � Should we begin an ancillary business? � Should we convert to another practice management software package? We have seen law firms lose potential revenue by overlooking billable time entries or losing track of reimbursable expenses. We have been called in to help firms that disregarded the significance of detection controls only to find that account balances were misstated and financial reports were erroneous. The costs of correcting these mistakes — in dollars and partner perceptions — were high. An accounting department, like every other support services department, must be evaluated in any cost-reduction initiative. Our caution and recommendation is to make sure that you are making a value assessment regarding your financial management needs. In many cases, increasing the firm’s investment in financial management talent may be the best way to improve law firm profitability. John T. Niehoff, CPA, is a partner in the Law Firm Services Group of Beers & Cutler, specializing in audit, tax, and business consulting services to law firms. He can be reached at [email protected] or (202) 778-0224.

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