Law Firm Profitability: It’s All in How You Count It

Topics: Law Firm Profitability, Law Firms, Leadership, Thomson Reuters

As many are probably aware, Congress has, for some time, been tinkering with the idea of tweaking the tax code to change the way law firms report and pay taxes on income. While the concept seems a bit esoteric, the implications for most firms in the medium and large law firm space could be quite dramatic.

As part of the pending Tax Reform Act, Congress is looking to enact law that would require all professional service firms, including law firms, with annual gross receipts of more than $10 million to use an accrual method of accounting rather than the more common cash accounting method. Today, most law firms report income when clients pay their bills. Under the new law, income would be attributable to the firm at the time it is earned.

This proposed change in the law has stirred up much interest. The American Bar Association (ABA) has been fairly vocal in its opposition to the change, highlighting what it sees as “unnecessary new complexity in the tax law and increase[d] compliance costs.

Jean O’Grady, of Dewey B Strategic gave the proposal her tongue-in-cheek “Worst piece of proposed legislation for law firms Award.” She sees the new law as one that could “wipe out all the staffing and process efficiencies law firms have gained since the recession with the stroke of a pen.”

As a counterpoint, James Loeffler of LegalEye recently argued during a webinar he and I co-presented with Peter Secor of Pepper Hamilton that accrual method accounting actually gives law firms a better basis from which to understand their profitability. His argument is it gives better real time reporting of results since it is not dependent on the lag involved with a client actually paying their bill, and it provides a better apples-to-apples comparison across matters. This is true, and makes for a compelling argument for a voluntary shift to accrual accounting. But this is a different situation than that presented by the proposed legislation.

Today, the difference between a firm’s standard rates and its realizations represents a drain on potential revenue, which is bad enough. Under the new law, this difference between rates and realizations would represent an accounting nightmare as income would be reported based on rates billed to clients, and any subsequent write-down or deviation would require an adjustment to the firm’s taxes that may easily span tax years.

According to Peer Monitor, firms currently experience about 83% collected realization on their rates, an historic low, by the way. If a firm is taxed on the accrual of their standard rates, that means an average of a 17% adjustment in income after the bills are actually paid.

Clearly there are myriad potential problems with the proposed tax law changes.

But I think it also present a strong argument in favor of Alternative Fee Arrangements (AFAs), and in particular flat fee agreements. In theory, a flat fee agreement should lead to 100% realization of the agreed-upon rate. Working with a fee arrangement that would provide a more solid picture of expected revenue would alleviate much of the additional burden a change of accounting methods would present.

Obviously, not all work lends itself to flat fee arrangements. And there is significant work involved in ensuring that such an arrangement would be a profitable venture for the firm. But given the stated desire by clients in survey after survey to see additional AFAs offered by their counsel, and the looming specter of additional accounting headaches related to traditional hourly billing, the investment into developing an effective and profitable AFA strategy may be a wise long-term investment.