Hi, Finance – May

“Our income is not the same as our fees. Is that wrong?”

The problem

Most law firms and managers within those firms, such as Department or Team Heads, tend to monitor performance by looking at the fees billed by each fee earner/team/department, or the firm overall.

This may be compared to a budget and any significant difference will be looked reviewed. It may be grumbled at if it is lower than budget, or congratulated on if well over budget.

However, when the firm’s Accounts are prepared, the total income figure is often quite different from the total fees billed and this causes confusion, especially if the income figure is lower than the fees billed, (and therefore profit is significantly less than expected)! As explained in another article, a 5% reduction in income could lead to e.g. a 20% reduction in profit. For any firm that reduction in profit would matter.

The reason

When preparing accurate accounts for law firms, accounting rules say that the income for the year must be the billable value created in the year – whether billed or not. What does that mean and how do we measure it?

The value created is best explained by thinking of a brand-new starter at a law firm. After induction, they start working on their first file and immediately they do something to progress the matter, they have started creating value for the client. It has value because the client will eventually pay for that work. We do not necessarily know how much we will bill for that work but, nevertheless, it has value. They then start on another file and in the same way, create more value for the firm. Over the hours, days, weeks, and months, that fee earner works on a several files and builds up value for the firm. It may not yet be billed but that unbilled work does have value.

That value is, or at least should be, the accounting income for the accounting period. So, in theory, you could have a whole year without having billed anything or collected any cash but still have a profit, (if that value created was greater than your costs). I do not recommend that strategy by the way and I doubt your funders would either!

The solution(s) measuring the value created

The easiest way is to bill the work out. By billing the work, you crystallise the value that has been created. Adjustments may yet be made for slow payers or bad debts but actually billing the work is the starting point.

That leaves us with the work done – but unbilled – at any accounting period end: typically, month-end or year-end.

Somehow, a value must be ascribed to that work. There are several ways of valuing the work but broadly speaking they are as follows:

• Fixed fees – as long as the work has progressed to the point, or points, where a certain amount is contractually due from the client, we can value that work at the fixed fee. Any extras, outside the scope of that fixed fee, must be billed separately and in addition – but valued in one of the following ways;

• Where good time records are maintained, such that the Work in Progress, (WIP), figures are accurate, they can be the basis for valuing that unbilled time. The recent recovery rate, (or billable rate), of that WIP can be applied to that raw data to produce a good estimate of the value of the outstanding WIP.

  For example, historically, a particular fee earner’s time might have been billed out at 95% of its recorded value. At the year end, the firm had £10,000 of that fee earner’s outstanding WIP. It is therefore reasonable to say that the value of that WIP is £9,500, (£10,000 WIP x 95%).

• You can ask fee earners to go through their matter ledgers at the month or year end and ascribe their best estimate of the likely billable amount to the amounts on those ledgers. Note this estimate must only be in respect of the unbilled work at the period end and not be inflated to include any future work.

• Wait for the work to be billed and use that actual value. Obviously, this usually prevents quick production of the month-end or year-end figures and therefore I do not recommend it – but it would be accurate!

Conclusion

A fee earner who has – say – billed £150,000 during the year and has a further £9,500 unbilled value, (as in the example above), would have created a total of £159,500 during the year. It is the £159,500 that would be the income figure and that is why the fees and income figure would not match.

Just to complete the picture, it gets a little trickier if the fee earner has unbilled value at the start, as well as the end, of the period. Some of that opening unbilled value will be billed during the period and some might be carried forward at the end of the period. Using the figures immediately above if, in addition to those values, that fee earner had £7,000 of value brought forward, the £159,500 would be reduced by £7,000 to £152,500. That reflects the fact that £7,000 of that income arose in a previous accounting period and not in this one. As I mentioned under The Reason above, it is the value created in the period that gets included in accounts. The tricky bit is measuring it.

Finally, this process can be automated, e.g. by the use of data exports from accounting systems and the application of relatively simple spreadsheets or by the use of other tools. With a disciplined approach, the monthly and indeed the annual income figures per fee earner, team, department, or the firm, can be produced within hours of the period end. If your firm does not do that, then please feel free to challenge them to do so!