Many attorneys receive periodic financial statements from their accountants but do not fully understand those financial statements. Many times, the financial statements are provided to the attorney after too much time has passed and are therefore not as meaningful. Other times the attorney perceives errors in the financial statements and dismisses their usefulness. The perceptions often are incorrect and are the result of not being properly advised on how to read the financial statements. All of this makes for attorneys not getting the maximum benefit from having financial statements prepared for them.
The two most often prepared financial statements are the balance sheet and profit and loss statement. However, there is another financial statement called the statement of cash flows that has very valuable information, yet is routinely not prepared at all. We will talk about the statement of cash flows later.
THE BALANCE SHEET
Most law firms keep their books on a cash basis, which reports cash in and cash out only. Whereas cash is king, the attorney should also be advised on what the current client receivables balance is as compared to the same period for the prior year. The attorney should also be advised on the aging of the receivables, such as 30-day-old receivables, 60 days, etc. But keep in mind how the client receivables have changed from the prior period to the current period as a decline in receivables could mean a problem is brewing.
The balance sheet is as of a set day, say at midnight of the date listed. So the cash balance is exactly that amount on that date. Equipment is usually listed at its purchase price and then reduced for depreciation taken over the years up to that date. Liabilities are reported at their payoff amounts as of the same date. Note though that most liabilities on the balance sheet are only for loans taken for the purchase of equipment, vehicles, etc., so that regular accounts payable, like rent, supplies, taxes are not listed. If the law firm is not paying these monthly type liabilities timely, those liabilities can be an indication of financial problems that are not noted on a cash basis balance sheet. What is left after subtracting the liabilities from the assets is the law firm’s equity. The law firm’s equity indicates the general financial well-being. However, keep in mind that the balances in the client receivables and accounts payable must be considered in any assessment of financial well-being of a cash basis prepared balance sheet.
All financial statements prepared for attorneys should be comparative with the prior period. So if the attorney is looking at 12-31-18 financial statements, those statements should have a column with the 12-31-17 numbers. Comparing the current period with the prior period numbers is extremely helpful in understanding trends, checking unusual variances in collections and expenses, comparing to budgeted numbers and for benchmarking against industry standards. Budgeting is a very helpful tool to see if goals set at the beginning of the year are being met. Benchmarking by using common industry standards for various expense categories to see how the law firm compares to other firms is also important in understanding how well or poorly a law firm is doing. The discussion here is very basic. There is a large amount of informative data from various sources, including the American Bar Association, on financial statement ratios and types of financial data for law firms. A simple search under “law firm financial ratios” will provide various useful resources.
THE PROFIT AND LOSS STATEMENT
The profit and loss statement should clearly spell out the sources of client collections, the various types of expenses and be comparative with the prior period of time. This statement should also have budgeted numbers and benchmark data for the reasons discussed above. In addition, the P/L statement should provide the attorney with a clear understanding of the financial results for the attorney’s hard work. This is done by isolating the compensation to the attorney. This compensation is from salary, other types of compensation or cash withdrawals given and fringe benefits, such as health insurance, retirement plan contributions for the attorney, payroll taxes paid on behalf of the attorney, vehicle allowances, etc. Isolating this compensation information allows the attorney to clearly see the “bottom line” of what is truly earned from the client collections.
THE STATEMENT OF CASH FLOWS
Finally, there is the statement of cash flows that unfortunately is rarely prepared for the attorney. This statement is designed to clearly show the attorney for a stated period of time (example, the year-end statement of cash flows would report the cash sources and cash uses for the twelve months of that year) where cash is coming from and where cash was used. So often attorneys find themselves working harder and making less money. The statement of cash flows can show the attorney where the cash went over a defined period. This statement is difficult to understand at first glance so the accountant must explain the format and accounting terms used.
One of the main points to be made here is that you need to get more out of the financial statements prepared for you. Your accountants need to take a stronger role to make sure you have the financial information you need to manage your law firm. Jim Rice, CPA
