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published February 11, 2013
The typical law office spends 45 to 50 percent of the fee dollar on the expenses of operating the office. These funds go for non-lawyer salaries, rent, telephone, library, equipment, supplies and other facilities. The comparison of overhead percentage ratios is, in fact, quite a game among some lawyers. We are often asked: "What should a law firm's overhead ratio be?" An answer such as 45 percent, derived from some recent survey, will often satisfy the questioner; or he may be unhappy because he realizes that in his shop, the figure is higher, say 55 percent.
Actually, the percentage ratio of overhead is quite unimportant and firm to firm comparisons of this number may be misleading. One Western firm of three lawyers that provided information to the authors for 1987 showed an expense ratio of 60 percent. Non-lawyer salaries alone were taking 30 percent of every fee dollar. Some firms of that size can operate on a 38 percent total expense ratio!
But the lawyers of that firm averaged income of $175,000 each in 1987, a figure far above normal. The firm used paralegal assistants and modern techniques to improve the productivity of its lawyers rather than hiring more lawyers. Such innovations change overhead ratios from the "norms" quoted in some quarters, but the dollar rewards of such organization speak for themselves.
In calculating the percentage of gross receipts spent on overhead, the compensation of all lawyers is normally excluded. That is, all payments to lawyers are treated as part of "profit." Unless this is done, a firm will be unable to compare its own year-to-year overhead ratio. Here's why:
Actually, what we have termed "profit" here is really "lawyer compensation." If Green and Jones now become a professional corporation, and still want to compare their year-to-year financial results, they will have to adopt the latter term.
The overall percentage or proportion of gross fees a firm expends on all cost items is not important. For the firm with an entertainment clientele which needs posh offices, it helps little to know that the average law office expends about eight percent of its gross on occupancy. A firm which has developed the paralegal concept to the point where it employs an average of four non-lawyers to each lawyer will not meet the "norm" of spending eighteen percent of gross on non-lawyer employment costs. The fact that most firms spends one percent of fees on library will not impress the senior partner with a love for books, nor the isolated small town firm which must maintain a substantial library.
Actually, the ratio of expenses to gross fees will change dramatically if billing is increased while the line is held on expenses. Quite often, the law firm which seeks consulting advice because of a high overhead ratio needs help not in controlling its costs, but in its methods of billing and collection. On the other hand, many very prosperous law firms operate with a very high percentage of overhead costs. It often takes money to make money.
In a partnership, paid-in capital consists of funds belonging to individual partners which have been turned over to the firm. Generally speaking, these accounts divide into two distinctively different parts:
When a law firm purchases an item that cannot be expensed in the year of purchase, the result is an addition to the partners' capital accounts. For example, most office machines will be depreciated over a period of five years. If straight depreciation is used, this means that 20 percent of the value of the machine will be reported as an expense each year. In the first year, the other 80 percent comes out of the after-tax pockets of the partners.
There are various methods of crediting the amounts to partners' individual accounts. Most often, each partner is charged with such expenditures in the proportion of his or her interest in the profits of the firm. In other words, a partner who will receive 30 percent of firm profit will also make a 30 percent contribution to nondeductible expenses. By the same token, the partner will receive 30 percent of the depreciation credit for purchases of former years. A firm may, however, allocate capital contributions in a different way from profit distribution. This requires a specific agreement.
Most firms pay their partners on a regular weekly or monthly schedule. But some pay partners only when a drawing is requested by one of them. This may mean that some partners leave their shares of money in the firm, while others may withdraw their share, or more. When this happens, cash capital accounts must be constantly altered.
Some partnerships make a distinction between required cash capital or reserves and temporarily-held profit.
In a corporation, capital is usually contributed in the ratio of shares owned, but not necessarily in any correlation with compensation received. Only profits must be distributed on the basis of shares in the form of dividends, but in law firm corporations most of the owners' compensation will result from being employees rather than shareholders.
Little attention is paid by many law firms to matters of cash flow and short term investment of firm funds.
Some law firms insist on a substantial reserve of cash. Few firms need more cash on hand than the expenses of one month of operation, and some can get by on less. (Exceptions are firms which deal in few, large matters which cause very irregular cash flow). A line of credit with a bank may be as good as a substantial cash reserve.
Professional corporations may require short loans at the end of the year to guard against reporting substantial profits. Otherwise, a professional corporation which has purchased any amount of capitalized items, not deductible in the year of purchase, will show a book profit, even though the funds are expended. The Federal and state governments will then levy a tax on the profits. A loan enables the corporation to run out enough bonuses to employee-owners to minimize profit.
Quite often, law firms accumulate substantial sums of money during the year, and some allow such funds to sit idle. This only means that the bank, rather than the lawyers who own the funds, will collect interest on the deposits. Accumulations should be invested, either in interest-bearing accounts or certificates of deposit, or in higher yielding short term commercial paper. A good broker can be an invaluable help in managing such funds.
Near the end of the tax year, billing should consider the time-of-payment factor. Depending on how the year has gone, a firm's management may want to accelerate or slow up collections. This factor should receive constant attention during the last quarter of any year.
The development of a budget for expenditure of funds is important both as a goal setting device and also as a means of delegating authority for expenditures without the need for a managing group to become involved in each specific purchase. In some law firms too much time is wasted in discussions of the merits of specific items of equipment or the need for an additional adding machine. A budget, which is adopted once a year by the governing body, can shortcut some of these discussions and enable a firm to plan its finances more carefully.
Budget for Expenses, while not complete in every detail, is a type of budgeting method which might be used by a more substantial law firm. Disbursements on behalf of clients are included as a reminder that this can be a source of considerable unprofitable investments for a law firm. This specimen partial budget states a summary of the firm's policy regarding disbursement.
The budget may delegate spending authority to various positions. In the illustration, the managing partner is assigned responsibility for purchase of hardware while the business manager has received authority to expend funds for salaries and supplies, etc. Another approach is to give an office manager a maximum spending authority, including the right to sign purchase contracts, up to a certain amount, i.e., $500; reserving to a managing partner or an executive committee the right of approval of any more substantial expenditure.
The firm that wants to hold one or two individuals responsible for determining the level of expenditures must, of course, give them the necessary authority to deny purchases even when requested by partners.
No budget can foresee all of the possible events which will occur within the budget period of one year. In our illustration for example, we have shown an item of $12,000 for printing and supplies. Turnover in the professional complement of a firm might quite easily cause an increase in that budget beyond $12,000. This would not be within the control of the business manager. Normal budgetary procedure is for the business manager to prepare a supplemental budget for the additional, required funds and to have it approved by the prescribed authority within the firm.
The same principle applies to all goal-setting activity. It is not always possible to foresee the contingencies which will arise, and consequently, goals may need review and alteration during the goal period. The stated goals must always be realistic.
Advances made in a client's behalf for filing fees, expert witnesses, or for specific items purchased for use in a legal matter, have traditionally been billed to clients as "costs advanced" or "disbursements made" in the client's behalf.
Decades ago it was necessary for most law firms to take papers outside of their office for copying, but today firms have their own copiers and provide the service to their clients. Some firms which had no hesitancy in passing along the cost for outside copying have hesitated to bill clients for the cost of in-house copying. A majority of firms do charge clients for this service at cost, often on a hit or miss basis. Where a long distance phone call is required to advance a client's matter, the toll charge is generally billed to the client. Where the client's convenience or the cause of his legal matter is served by the lawyer traveling out of his home town, the client is usually charged for mileage, plane fare, tolls and parking. The test appears to be "Does all of the legal work of this firm require this expense, the cost of which is included in the lawyer's hourly rate or does the need for this service vary from case to case?" In the latter case, it would be inequitable to charge all clients pro rata for it. Clearly the client whose work can be done in the lawyer's office should not share the expense created by another client who requires that the lawyer travel a hundred miles on his case. This extraordinary expense is not part of the general cost of doing business which is factored into the lawyer's fee structure.
This philosophy can be applied to other instances of costs advanced for the benefit of the client and his cause: providing notarial service, using registered or certified mail rather than ordinary mail, requiring secretarial overtime because of the client's case (not the procrastination of the lawyer), special duplication, photographs, and the like.
Some firms even charge secretarial time to clients independently of the lawyer's time, on the theory that some matters take little professional time and a great deal of clerical time, whereas other work requires lawyer time heavily and little clerical work. In this case, of course, the full cost of clerical salaries and benefits should not be used in determining the lawyer's hourly rate. A rate will have to be established for clerical chargeable time. This type of clerical and lawyer hourly rate structure is becoming increasingly necessary because of the growing number of paralegal employees. If a paralegal has a billable rate, the whole overhead for that paralegal should not be included in computing a lawyer's billable rates, any more than the cost of employing an associate would be included in computing a partner's hourly rate.
The most troublesome cost-advanced items, in terms of record keeping, are the small costs, such as petty cash, telephone charges, postage and photocopy charges. The collection and posting of these charges can be accomplished in a number of ways. Some systems, however, are grossly inefficient and generally result in losses.
Many offices have used lists for such charges. A sheet may be placed beside the photocopy machine and staff is instructed to write the client's name and the charge on the sheet, as copies are made.
Monthly, or more often, the bookkeeper must distribute these charges on a spread sheet in order to arrive at the amount to be charged to each matter or client. This is an inefficient and time-consuming process and is subject to error.
A better alternative is to complete a voucher slip for each charge. This is cheaper for the simple reason that the voucher slip can be sorted, while a list must be copied. It is more efficient to sort than to copy and recopy.
It is possible to have the telephone long distance operator call back with time and charges if the call is placed through an operator, but this costs additional money and clerical time. Direct dialing is the most reasonable and the most used method for long distance telephone work, but is the most difficult to control.
As the voucher slips are completed they should go to a central location, such as bookkeeping, where they will be held in date sequence until the telephone bill is received. At that time, by using reference to the date and number, the charge can be entered on each slip and the tax added. The slips would then be totaled and one entry made to the client's ledger for all of the calls to be charged. The slips may be retained until the bill is paid or a few months thereafter. Since the telephone company bill is the primary record of the expense, there is no need to retain the voucher slips for a long time.
A similar procedure can be used for the voucher slips completed for photocopying, postage and petty cash, with the one ledger entry for each or a combined total entry placed in the client's ledger.
Any law firm can realize the recoupment of many dollars of expense through better control over costs advanced for clients. If they are not recouped from the client they will come from the lawyer's pocket. One New York law firm of twenty lawyers reported an increase of $15,000 in costs reimbursed to the firm in a six-month period after a tight control was begun over miscellaneous costs advanced.
The trust account is called by a variety of names in different areas. In some locations it is called the "client account," in others, the "escrow account" or the "attorneys' account." What it is called, however, is not nearly so important as the way in which this bank account is controlled and supervised.
Following is a series of guidelines handed down a few years ago by the Arizona Supreme Court, which details the proper handling of a trust account in a law firm.
The following guidelines have been adopted by the Board of Governors of the State Bar of Arizona, pursuant to Rule 29(f) (5), Rules of the Supreme Court, in order to set minimum standards to ensure that each member is in compliance with the provisions of Disciplinary Rule 9-102, Code of Professional Responsibility, and Rule 29(f), Rules of the Supreme Court, relating to trust accounts.
"DR 9-102. Preserving Identity of Funds and Property of a Client.
(5) The maintenance of trust accounts by members of the bar and the audit of lawyer's trust accounts as provided by this rule, shall be in accordance with minimum guidelines established by the board of governors.
Minimum Requirements for Books and Records Maintenance
As a minimum requirement, every attorney engaged in the private practice of law in the State of Arizona shall maintain on a current basis, books and records which establish his compliance with DR 9-102 and Rule 29(f)(1), and which shall be preserved for at least five years following the completion of his fiduciary obligation. For this purpose the following books and records are required for all fiduciary funds and property (including all funds held for clients or others):
Any funds received as fees by the attorney from the client shall be deposited in the attorney's trust account until earned, unless there is a written agreement with the client that such fees are earned at the time paid.
Legal Expenses means the fees, costs and expenses of any kind incurred by any Person indemnified herein and its counsel in investigating, preparing for, defending against, or providing evidence, producing documents, or taking other action with respect to any threatened or asserted Claim.
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