Will Your Firm Pass a Stress Test?

The recent economic crisis put a strain on many law firms. Although there has been a tepid recovery, trends in the industry continue to expose weaknesses, as highlighted by the recent demise of a large, reputable law firm, Dewey & LeBoeuf LLP. In fact, over the last 25 years, more than 40 major law firms have gone bankrupt. How is it possible that outsiders and a majority of partners saw no warning signs before the sudden collapse of the Dewey firm and many others like it? What causes a law firm to suddenly implode?

There are common threads among law firm failures over the past few decades: failures of appropriate governance, inaccurate financial reporting and excessive leverage. These issues underscore the need for a change in law firm governance. It remains to be seen whether the current risks in the economy will accelerate the trend toward a more corporate style of partnership governance that is employed in some large firms.

Firms have navigated through issues to address profitability in the short run. However, changes in the marketplace for legal services are threatening the ability of firms to maintain growth in the long run. These external threats include increased price competition, commoditization of legal work and competition from in-house legal departments. Effective leadership and some rethinking of the law firm business model will be required. As competition intensifies and profit margins narrow, successful law firms will be the ones positioned to deal with threats and capitalize on opportunities.

Internal Threats

Internal threats pose just as serious a risk to the health of a law firm as external threats if not properly managed. Does your firm have appropriate governance including management oversight and reporting structures necessary to survive and thrive in the face of these threats? If risk is not properly managed and the firm's financial position is not properly evaluated, your firm may be vulnerable to potential shocks.

Partners, prospective partners (including laterals), lenders and clients are increasingly aware of and concerned about these risks, and whether or not a law firm is prepared to deal with them. Conducting a stress test evaluation is a highly effective way for a firm to measure its ability to deal with existing threats and assure its partners and clients that it is appropriately managing the organization for long-term success.

We have helped our law firm clients perform such evaluations and have broken down the components to the following key areas:

• Firm Governance;
• Financial Reporting;
• Risk Management;
• Fiduciary Practices; and
• Evaluation of Financial Health.

The test results should be viewed as a report card that grades the firm on its performance in each area.

Firm Governance

The backbone of every law firm is its governance structure.

With respect to the firm's ability to deal with “stress,” there must be an appropriate, well-functioning governance structure, management oversight and risk management process. The appropriate governance structure evolves as firms grow and needs to be flexible enough to change as a result of mergers, new leadership or other factors. The governance structure should be aligned to the firm's strategy and business needs while allowing for accountability.

The relationship among partners, the manner in which partners are made and the conditions under which they are removed, the sub-organizations through which the firm operates, and the process through which a firm develops and maintains its intellectual capital, are all key elements of governance in a law firm.

There is no generic governance solution that is appropriate for every firm, but some key principles and practices have demonstrated their value. Best practice is to have a partnership board, executive board, and practice leaders with well-defined roles and goals. A strong partnership agreement and clear and direct lines of reporting both contribute to good governance.

The executive board typically consists of the managing partner/CEO, COO, and heads of the other professional function areas, including finance, marketing, HR and selected practice group leaders. This group is tasked with overseeing and guiding the operational and financial performance of the firm.

The practice group leaders are responsible for driving the execution of the business plan, targeting measurable goals.

The stress test scores firm governance on three main factors: governance structure, dispute resolution and succession planning.

Effectively managing conflict creates an atmosphere that allows for open, honest discussions and critical thinking. It also helps prevent groupthink, which often results from conflict avoidance. The key factors we consider in assessing dispute resolution are:

• Does the firm have procedures in place to address and resolve partner disputes?
• Is the process viewed as objective and impartial by the partner group?

Well-planned successions enable a smooth transition of clients and leadership to the next generation of law firm leaders. The key questions we ask when assessing succession planning are:

• Does the firm have a succession plan in place?
• If so, is it comprehensive and does it have the general backing of the partnership?

Financial Reporting

Accurate, detailed financial reporting is critical to management of a law firm. An assessment of the firm's financial reporting should analyze the accounting reporting methods employed as well as the competency of accounting and finance personnel.

The accounting basis of reporting should be appropriate for the organization. If cash basis financials are used, the firm needs to have a strong understanding of where it stands on an accrual basis, particularly in terms of work in process, accounts receivable and payables.

Weak internal controls or management override of controls could subject the financial reporting process to manipulation. The following questions should be considered related to controls:

• Does the firm have a policy that provides for a hard cutoff of collections at year-end?
• Could trust/escrowed funds be diverted to operating funds and recorded as revenues?
• Could the timing of payments be manipulated in order to conceal undisclosed liabilities?
• Could management manipulate capital expenditures and the related depreciable lives and methods in order to manage earnings?

Another area of financial reporting that we evaluate during the stress test is the competency of accounting and finance personnel. The firm's accounting staff should be adequately trained and knowledgeable in accounting and industry practices. Staffing levels should be appropriate for the needs of the firm, and the highest level accounting/finance position (e.g., CFO, controller) should have sufficient education and experience commensurate with the firm's size and complexity.

Technology can help employees manage time efficiently, increase productivity levels, and ensure data security. Accounting software and system controls over financial reporting should include general ledger as well as time and billing systems appropriate for the size and complexity of the firm. The firm should train employees to take advantage of all applicable accounting software functionality.

Internal controls over financial reporting should be appropriate for the organization's size, and the firm should have a strong control environment that provides for close review and monitoring of critical areas. The job duties of accounting personnel factor into the internal controls process. Adequately segregating duties can prevent conflicts that are incompatible for internal control purposes.

What is the managerial tone at the top of your firm with respect to financial reporting? Does management place a high priority and importance on accurate and thorough financial reporting? While a strong emphasis on financial reporting is generally graded positively, putting excessive pressure on meeting financial targets could backfire.

The stress test also assesses the level of transparency of financial reporting at a firm. For example, are firm financial records readily available for partners to review upon their request? Does the partnership group have confidence in the accuracy of the financial information provided to them?

Finally, we evaluate the daily, weekly, monthly, quarterly and annual financial information reviewed by management to determine if it is comprehensive. Factors we consider:

• Is financial information available to management on a timely basis? If not, why?
• Are budgeted results compared with actual results, including detailed explanations of variances? Amounts should be reviewed and discrepancies questioned by management.
• Does management use a dashboard to monitor financial results on a real-time basis?

Risk Management

The next area of the stress test is risk management. It is important to evaluate client acceptance procedures, insurance coverage, lines of reporting, and general counsel's access to information.

How are clients accepted into the firm? An appropriate mechanism should be in place to avoid conflicts of interest and to otherwise ensure full compliance with all applicable ethical rules, laws and regulations. The firm should not retain clients who may be unsuitable due to credit risk or reputation risk.

Maintaining an adequate level of insurance coverage can help prevent large losses from crippling the firm. Questions to ask:

• Does the firm use a high-quality insurance provider?
• Does the firm assess its coverage limits for adequacy on a regular basis?
• Are defalcations from trust/escrow covered?

Appropriate lines of reporting between the individuals responsible for risk management and/or general counsel to management keep the channels of communication open and help prevent mismanagement. The firm's general counsel needs to have timely, open access to all relevant information relating to the firm's ongoing legal issues and potential claims.

Fiduciary Practices

Bar association rules of professional conduct promulgate basic fiduciary standards, including responsibilities related to record keeping and the handling of funds and property. A breach of fiduciary duties is a serious act. Yet one of the biggest weaknesses we see in firms is that many do not have adequate controls surrounding trust account activities, especially when trust activities occur at multiple offices.

An evaluation of internal controls surrounding trust accounting should address:

• Who can open trust accounts?
• Who reconciles trust accounts?
• Is a monitoring function in place that would flag unusual activity?
• Who approves and reviews requests for trust distributions (including dual signature requirement and required documentary support for approval)?
• Who monitors stale funds?
• What controls are in place around commingling of funds?

Evaluation of Financial Health

The final key area that the stress test evaluates is the overall financial health of the firm. This assessment takes a comprehensive look at cash flow, capital structure, degrees of leverage, and key financial metrics.

To ensure adequate working capital, the firm should project and monitor its short-term and long-term cash flow needs. It is important that the firm maintains capital balances commensurate with its needs. A variety of factors affect the appropriate capital structure, including firm size, type of entity, partnership agreement, firm culture, and consistency in earnings.

A firm's use of debt financing varies depending on a variety of factors, including firm size, culture, expansion cycle, seasonality or cyclical practice areas. Firms need to carefully monitor their use of debt to ensure that they are not putting the financial health of the organization at risk.

Analyzing the following metrics can help determine if an organization might be overleveraged with debt and/or overcommitted on its financial obligations:

• Collectable value of WIP and Accounts Receivable/total debt;
• Total debt/net fixed assets;
• Evaluation of pipeline projects;
• Violation of loan covenants;
• Line of credit balances throughout various points of the fiscal period;
• Negative equity;
• Existence of financial and performance guarantees made by firm and firm's shareholders;
• Unfunded pension obligations;
• Existence of guaranteed compensation commitments not tied to performance; and
• Terms and breadth of leasing arrangements.

Other key financial metrics that can be assessed by benchmarking to determine how the firm compares with its peer group include:

• Revenue per partner;
• Income per partner;
• Capital as percent of profits;
• Realization percentages;
• Utilization;
• Expenses as percent of revenues;
• A/P Aging;
• WIP and A/R Aging;
• WIP and A/R to Debt;
• Liquidity;
• Months of free cash flow in WIP, A/R; and
• Cash available at year end to pay expenses, distributions on par with PY, retirement contributions.

An additional factor to consider in assessing a firm's overall financial health is attorney turnover, which should be monitored against industry averages and evaluated on qualitative aspects ' financial, political, cultural and other.

Valuable Tool

An annual stress test can evaluate the critical areas of firm governance, financial reporting, risk management, fiduciary practices and financial health. Monitoring these factors can help a law firm prepare to weather both internal and external threats. This assessment can be a valuable tool to identify potential weaknesses and avoid the pitfalls that caused the downfall of so many prominent firms. A clean bill of health goes a long way to relieve partner anxiety about the ability of a firm to remain a viable organization for many years to come.

Steven A. Davis, CPA, leads the accounting practice at Kaufman, Rossin & Co. He provides internal control and sophisticated consulting engagements to law firms. Marc Feigelson, CPA, is a principal in the assurance and advisory group at Kaufman, Rossin & Co. He has provided audit and consulting services to law firms, entrepreneurial businesses and public companies. Tyler Quinn, CPA, is a supervisor in the audit department at Kaufman, Rossin & Co. He provides integrated audit, SAS 70 and consulting services to clients in various industries. They can be reached at [email protected], [email protected] and [email protected], respectively.

The recent economic crisis put a strain on many law firms. Although there has been a tepid recovery, trends in the industry continue to expose weaknesses, as highlighted by the recent demise of a large, reputable law firm, Dewey & LeBoeuf LLP. In fact, over the last 25 years, more than 40 major law firms have gone bankrupt. How is it possible that outsiders and a majority of partners saw no warning signs before the sudden collapse of the Dewey firm and many others like it? What causes a law firm to suddenly implode?

There are common threads among law firm failures over the past few decades: failures of appropriate governance, inaccurate financial reporting and excessive leverage. These issues underscore the need for a change in law firm governance. It remains to be seen whether the current risks in the economy will accelerate the trend toward a more corporate style of partnership governance that is employed in some large firms.

Firms have navigated through issues to address profitability in the short run. However, changes in the marketplace for legal services are threatening the ability of firms to maintain growth in the long run. These external threats include increased price competition, commoditization of legal work and competition from in-house legal departments. Effective leadership and some rethinking of the law firm business model will be required. As competition intensifies and profit margins narrow, successful law firms will be the ones positioned to deal with threats and capitalize on opportunities.

Internal Threats

Internal threats pose just as serious a risk to the health of a law firm as external threats if not properly managed. Does your firm have appropriate governance including management oversight and reporting structures necessary to survive and thrive in the face of these threats? If risk is not properly managed and the firm's financial position is not properly evaluated, your firm may be vulnerable to potential shocks.

Partners, prospective partners (including laterals), lenders and clients are increasingly aware of and concerned about these risks, and whether or not a law firm is prepared to deal with them. Conducting a stress test evaluation is a highly effective way for a firm to measure its ability to deal with existing threats and assure its partners and clients that it is appropriately managing the organization for long-term success.

We have helped our law firm clients perform such evaluations and have broken down the components to the following key areas:

• Firm Governance;
• Financial Reporting;
• Risk Management;
• Fiduciary Practices; and
• Evaluation of Financial Health.

The test results should be viewed as a report card that grades the firm on its performance in each area.

Firm Governance

The backbone of every law firm is its governance structure.

With respect to the firm's ability to deal with “stress,” there must be an appropriate, well-functioning governance structure, management oversight and risk management process. The appropriate governance structure evolves as firms grow and needs to be flexible enough to change as a result of mergers, new leadership or other factors. The governance structure should be aligned to the firm's strategy and business needs while allowing for accountability.

The relationship among partners, the manner in which partners are made and the conditions under which they are removed, the sub-organizations through which the firm operates, and the process through which a firm develops and maintains its intellectual capital, are all key elements of governance in a law firm.

There is no generic governance solution that is appropriate for every firm, but some key principles and practices have demonstrated their value. Best practice is to have a partnership board, executive board, and practice leaders with well-defined roles and goals. A strong partnership agreement and clear and direct lines of reporting both contribute to good governance.

The executive board typically consists of the managing partner/CEO, COO, and heads of the other professional function areas, including finance, marketing, HR and selected practice group leaders. This group is tasked with overseeing and guiding the operational and financial performance of the firm.

The practice group leaders are responsible for driving the execution of the business plan, targeting measurable goals.

The stress test scores firm governance on three main factors: governance structure, dispute resolution and succession planning.

Effectively managing conflict creates an atmosphere that allows for open, honest discussions and critical thinking. It also helps prevent groupthink, which often results from conflict avoidance. The key factors we consider in assessing dispute resolution are:

• Does the firm have procedures in place to address and resolve partner disputes?
• Is the process viewed as objective and impartial by the partner group?

Well-planned successions enable a smooth transition of clients and leadership to the next generation of law firm leaders. The key questions we ask when assessing succession planning are:

• Does the firm have a succession plan in place?
• If so, is it comprehensive and does it have the general backing of the partnership?

Financial Reporting

Accurate, detailed financial reporting is critical to management of a law firm. An assessment of the firm's financial reporting should analyze the accounting reporting methods employed as well as the competency of accounting and finance personnel.

The accounting basis of reporting should be appropriate for the organization. If cash basis financials are used, the firm needs to have a strong understanding of where it stands on an accrual basis, particularly in terms of work in process, accounts receivable and payables.

Weak internal controls or management override of controls could subject the financial reporting process to manipulation. The following questions should be considered related to controls:

• Does the firm have a policy that provides for a hard cutoff of collections at year-end?
• Could trust/escrowed funds be diverted to operating funds and recorded as revenues?
• Could the timing of payments be manipulated in order to conceal undisclosed liabilities?
• Could management manipulate capital expenditures and the related depreciable lives and methods in order to manage earnings?

Another area of financial reporting that we evaluate during the stress test is the competency of accounting and finance personnel. The firm's accounting staff should be adequately trained and knowledgeable in accounting and industry practices. Staffing levels should be appropriate for the needs of the firm, and the highest level accounting/finance position (e.g., CFO, controller) should have sufficient education and experience commensurate with the firm's size and complexity.

Technology can help employees manage time efficiently, increase productivity levels, and ensure data security. Accounting software and system controls over financial reporting should include general ledger as well as time and billing systems appropriate for the size and complexity of the firm. The firm should train employees to take advantage of all applicable accounting software functionality.

Internal controls over financial reporting should be appropriate for the organization's size, and the firm should have a strong control environment that provides for close review and monitoring of critical areas. The job duties of accounting personnel factor into the internal controls process. Adequately segregating duties can prevent conflicts that are incompatible for internal control purposes.

What is the managerial tone at the top of your firm with respect to financial reporting? Does management place a high priority and importance on accurate and thorough financial reporting? While a strong emphasis on financial reporting is generally graded positively, putting excessive pressure on meeting financial targets could backfire.

The stress test also assesses the level of transparency of financial reporting at a firm. For example, are firm financial records readily available for partners to review upon their request? Does the partnership group have confidence in the accuracy of the financial information provided to them?

Finally, we evaluate the daily, weekly, monthly, quarterly and annual financial information reviewed by management to determine if it is comprehensive. Factors we consider:

• Is financial information available to management on a timely basis? If not, why?
• Are budgeted results compared with actual results, including detailed explanations of variances? Amounts should be reviewed and discrepancies questioned by management.
• Does management use a dashboard to monitor financial results on a real-time basis?

Risk Management

The next area of the stress test is risk management. It is important to evaluate client acceptance procedures, insurance coverage, lines of reporting, and general counsel's access to information.

How are clients accepted into the firm? An appropriate mechanism should be in place to avoid conflicts of interest and to otherwise ensure full compliance with all applicable ethical rules, laws and regulations. The firm should not retain clients who may be unsuitable due to credit risk or reputation risk.

Maintaining an adequate level of insurance coverage can help prevent large losses from crippling the firm. Questions to ask:

• Does the firm use a high-quality insurance provider?
• Does the firm assess its coverage limits for adequacy on a regular basis?
• Are defalcations from trust/escrow covered?

Appropriate lines of reporting between the individuals responsible for risk management and/or general counsel to management keep the channels of communication open and help prevent mismanagement. The firm's general counsel needs to have timely, open access to all relevant information relating to the firm's ongoing legal issues and potential claims.

Fiduciary Practices

Bar association rules of professional conduct promulgate basic fiduciary standards, including responsibilities related to record keeping and the handling of funds and property. A breach of fiduciary duties is a serious act. Yet one of the biggest weaknesses we see in firms is that many do not have adequate controls surrounding trust account activities, especially when trust activities occur at multiple offices.

An evaluation of internal controls surrounding trust accounting should address:

• Who can open trust accounts?
• Who reconciles trust accounts?
• Is a monitoring function in place that would flag unusual activity?
• Who approves and reviews requests for trust distributions (including dual signature requirement and required documentary support for approval)?
• Who monitors stale funds?
• What controls are in place around commingling of funds?

Evaluation of Financial Health

The final key area that the stress test evaluates is the overall financial health of the firm. This assessment takes a comprehensive look at cash flow, capital structure, degrees of leverage, and key financial metrics.

To ensure adequate working capital, the firm should project and monitor its short-term and long-term cash flow needs. It is important that the firm maintains capital balances commensurate with its needs. A variety of factors affect the appropriate capital structure, including firm size, type of entity, partnership agreement, firm culture, and consistency in earnings.

A firm's use of debt financing varies depending on a variety of factors, including firm size, culture, expansion cycle, seasonality or cyclical practice areas. Firms need to carefully monitor their use of debt to ensure that they are not putting the financial health of the organization at risk.

Analyzing the following metrics can help determine if an organization might be overleveraged with debt and/or overcommitted on its financial obligations:

• Collectable value of WIP and Accounts Receivable/total debt;
• Total debt/net fixed assets;
• Evaluation of pipeline projects;
• Violation of loan covenants;
• Line of credit balances throughout various points of the fiscal period;
• Negative equity;
• Existence of financial and performance guarantees made by firm and firm's shareholders;
• Unfunded pension obligations;
• Existence of guaranteed compensation commitments not tied to performance; and
• Terms and breadth of leasing arrangements.

Other key financial metrics that can be assessed by benchmarking to determine how the firm compares with its peer group include:

• Revenue per partner;
• Income per partner;
• Capital as percent of profits;
• Realization percentages;
• Utilization;
• Expenses as percent of revenues;
• A/P Aging;
• WIP and A/R Aging;
• WIP and A/R to Debt;
• Liquidity;
• Months of free cash flow in WIP, A/R; and
• Cash available at year end to pay expenses, distributions on par with PY, retirement contributions.

An additional factor to consider in assessing a firm's overall financial health is attorney turnover, which should be monitored against industry averages and evaluated on qualitative aspects ' financial, political, cultural and other.

Valuable Tool

An annual stress test can evaluate the critical areas of firm governance, financial reporting, risk management, fiduciary practices and financial health. Monitoring these factors can help a law firm prepare to weather both internal and external threats. This assessment can be a valuable tool to identify potential weaknesses and avoid the pitfalls that caused the downfall of so many prominent firms. A clean bill of health goes a long way to relieve partner anxiety about the ability of a firm to remain a viable organization for many years to come.

Steven A. Davis, CPA, leads the accounting practice at Kaufman, Rossin & Co. He provides internal control and sophisticated consulting engagements to law firms. Marc Feigelson, CPA, is a principal in the assurance and advisory group at Kaufman, Rossin & Co. He has provided audit and consulting services to law firms, entrepreneurial businesses and public companies. Tyler Quinn, CPA, is a supervisor in the audit department at Kaufman, Rossin & Co. He provides integrated audit, SAS 70 and consulting services to clients in various industries. They can be reached at [email protected], [email protected] and [email protected], respectively.