Well it has been more than a few weeks since the last edition of our series on the roles and responsibilities of the ‘Trusted Advisor’ to Law Firms. I have to apologize to both you, our readers, and Caren, my contributor in this series, because I have had so much on my plate I have focused on a lot of other articles and let this series lag behind, but no more. It is time we get back to it, because we know that a lot of accountants and ProAdvisors are developing their ‘Epic practices’ by specializing in law firms. We also know that law firms in big cities and small are searching for trusted advisors to provide accounting and/or bookkeeping needs, as well as services related to their requirements related to Trust Fund management and reporting, client billing practices, case cost tracking, compensation methods, and practice management including case-tracking. As trusted advisors you may need to assist them with operational procedures and best practices, in addition to the selection and implementation of software associated with the law firm’s specific requirements.
In this article we will look at the methodologies associated with the proper tracking and allocation of ‘costs’. Typically, a trusted advisor will need to be thoroughly versed in the various methods and requirements for the proper administration and reporting of these costs, regardless of the software being used for such purposes.
Law Firms costs fall into several areas.
We must first differentiate that fact that in every law firm there are ‘firm costs’ and then there are ‘client costs.’
Firm costs - this would include costs such as rent, continuing education, payroll and all the other expenses of the firm as a business, regardless of whether you have clients walking in the door. For the most part these costs are ‘accounted for’ in the same manner as the respective type of business be that a sole proprietorship, partnership, S-corporation, or C-corporation.
Client costs - those expenses incurred on behalf of a client. Client costs are typically then subdivided into those costs that will be billed to the client, and those costs that the firm will incurs and not bill back to the client. One of the major factors associated with ‘to bill’ or ‘not to bill’ is determining the intention to bill as the relevant factor in determining how the cost will be accounted. Many times these costs will be set forth in the ‘representation contract’ between the client and the law firm.
If a law firm bills a client and then doesn’t get paid, then they will write-off the cost(s). On the other hand, if a law firm does not bill the client then the cost(s) represent an unreimbursed client cost. While this difference may seem subtle, it emphasizes the important of always tracking costs separately to know if the firm is taking on "problem cases" where they are not getting paid and thus having to do write-offs.
Client costs should also be segregated in another fashion, that being ‘Soft costs’ and ‘Hard costs.’
Soft costs - those costs the firm charges the client for, but for which the firm doesn't write a direct check. Such costs might include postage, copies on an internal copy machine, phone calls, faxes, internet based legal research library, and many other costs of doing ‘law’. Since you are not writing a check, tracking soft costs, and remembering to bill the client for them, can be more difficult depending on your billing system. For example, soft costs are more difficult to enter in advance for billing in QuickBooks.
Soft costs are usually an expense on the income statement. To track soft costs for clients in QuickBooks you have several alternatives. One is to keep a separate list and just enter the expense when preparing the invoice. A second option is to enter a dummy check or a journal entry. The debit would be to a Client Soft Costs and would include the client name. The credit would be to the appropriate expense account. For example, if the law firm has copier lease expense account and is willing to take the time to record a client cost for in-house copies, they would credit the copier lease account since they are actually recovering some of their copier lease expense and thereby reducing their ‘overhead’ costs associated with the copier. Many copiers and other devices have the capability to capture client ids and export a report of the quantity. These devices can save time and improve accuracy in capturing costs if you can export the data in a format usable by your software. Some firms have made clever use of the QuickBooks mileage tracking capability to capture similar soft costs in advance of billing.
Hard costs - costs for which a direct payment was made by the law firm on behalf of the client. Examples of these would include court fees, transcription fees, marshals or expert witness fees; it might also include additional professional services such as co-counsel from another firm, or a jury consultant. The IRS has rules about how hard costs should be tracked depending on volume. (Note: See page 34 at the website contained in the previous sentence.) In general, such costs should be tracked on the balance sheet, as opposed to the income statement. The advantages to tracking such costs on the balance sheet include accurate reporting across fiscal years, and the impact of high costs/high reimbursements across multiple years lessen the impact the tax return. In addition, it is easier to track who owes the firm for client costs when they are carried as costs on the balance sheet.
Whatever methods and mechanics you decide to use in tracking client costs, hard or soft, consistency is important to prevent double billing or missing the opportunity to recover costs. It is also critical if the tax man ever comes knocking on your door. Rick Kabra, the CEO of CosmoLex, told Insightful Accountant, “For lawyers, managing client costs is much more than saying this client owes this much. To have compliant financial records lawyers not only need to apply each cost to the appropriate matter, but it is also important that they differentiate between direct (or hard) and indirect (or soft) costs…” Mr. Kabra, who has over 10 years of experience in the legal software industry catering to the specialized needs of small to mid-sized law firms, went on to say, “Additionally, proper accounting safeguards are required in booking direct or hard costs be it as an expense or asset item.
Costs Paid from Client Funds.
We have previously discussed the critical factors associated with properly handling of client trust funds, and that includes ‘client costs’ paid from such funds, so we will not take to time to reiterate the details of doing so. Rather we simply want to re-emphasize the importance of proper trust accounting as set forth in our earlier articles on this topic.
If your client’s law firm is using electronic billing (Ledes, Litigation Advisor, etc.) each cost will have an E (expense) code. Fortunately, these are a less complex than the task/activity codes, as there is only one set of expense codes, as opposed to different types of task/activity codes for different types of law.
While some electronic billing firms require that a task code be associated with the submittal of expense codes, many of the electronic billing houses do not require this type of billing associations. If you, as the law firm’s trusted advisor are involved in performing, supervising, or instructing law firm personnel in the performance of electronic billing it is important to not only use the correct E codes (for example: E101 Copying vs. E102 Outside Printing), but it critical that you also submit the billing with the correct rate for that E code. Each electronic billing contract has specifics on both their allowed codes and rates. Use of an expense that is not allowed, or a rate that is incorrect, will cause the bill to be rejected, thus delaying payment and causing extra work for the law firm in reprocessing of the electronic billing and all related internal accounting.
Obviously the proper tracking, cost accounting, billing of client costs, both hard and soft, can have a major impact upon the profitability of a law firm, not to mention compliance requirements when client funds are involved. To this extent, Rick Kabra told us that, “Billing often gets looked at as a step at the end of the process of dealing with each client, but the firms that do it successfully have billing in mind all along the way. Their time (and case costs) are billable so ensuring that all billable activities are recorded as they happen is huge for law firms.”
Trusted Law Firm Advisors will have a firm grasp of not only the conceptual, but practical aspects of law firm cost accounting and billing, so they are prepared to assist their lawyer clients and firms with every aspect of this critical functionality.
Next time, in part 5 of this series, we will examine the measurements that are important to your law firm clients including how they choose to compensate the members of the firm (both lawyers and staff). Some firm members may be paid a salary, some maybe paid a draw against earnings, and some paid an hourly wage.
Note from the Editor: The website link contained in this article contains the official ‘Audit Guide’ of the Internal Revenue Service as it applies to Attorneys and Law Firms. Trusted Advisors who will be working with law firms are best advised to thoroughly review ALL of the provisions of this guide in order to assist their clients in strict conformance.