Strong financial management cuts fraud and increases profits

The realities of the economic recession related to the legal profession have resulted in what appears to be long term changes to the business model of law firms.

Many law firms are aggressively working to drive down the cost of providing legal services, to right size their leverage model of partners to associates and other professionals, and to reduce overhead costs. Law firm partners are beginning to refocus on strategic plans to drive revenue growth while financial management (from the controller to the executive director) is challenged to support revenue growth initiatives and to curtail expenses to enhance profitability.

In order to support these evolving business challenges, law firm financial managers need to supplement their financial reporting responsibilities with a few additional key areas that require their attention.

Fraud prevention

The 2010 Report to the Nations on Occupational Fraud and Abuse prepared by the Association of Certified Fraud Examiners (ACFE) notes that survey participants estimated that the typical organization loses approximately 5 percent of their annual revenue to fraud.

The report notes that in professional service organizations some of the more prevalent fraud schemes included matters involved with billing (including cash receipts), expense reimbursements, check tampering, payroll and cash on hand. To check the relevance of this broad report to the legal professional all you have to do is search the internet for news of law firm employee fraud. There are numerous cases of trusted office managers, bookkeepers, or lawyers who took advantage of existing opportunities to enrich themselves at the expense of law firms.

Fraud prevention is critically important for law firms to assess, irrespective of the size of your firm. Smaller firms are often more susceptible to simple instances of fraud when partners place too much trust in an office manager who has the ability to write fraudulent checks or transfer funds to personal accounts, and report the payments as an office expense of the firm. Larger firms also face fraud risks as evidenced by reports of attorneys who have billed personal expenses to their law firms and reported extra time for billing to clients, and a law firm employee who sold what was reported as 156 law firm office computers and monitors on eBay.

Another area where fraud has occurred at both large and small firms is with client fund’s held in trust accounts. Often these accounts are overlooked from a control and fraud detection standpoint because the balances do not represent operating funds of the law firm and activity tends to be more limited.

These examples of fraud serve as important reminders that anti-fraud techniques are important and can be effective in reducing losses and supporting law firm profitability. Law firm financial managers need to invest the time to evaluate risk factors in their organizations in order to develop fraud prevention procedures. Often these fraud prevention techniques can be implemented with little cost to the organization.

A first step would be to set an ethical tone for all employees that fraud will not be tolerated and that ethical behavior is a requirement for employment. This tone should be established in employee manuals and new employee orientations, as well as periodic discussion or communications at staff meetings or other broadcast mechanisms. And, the ACFE report notes that tips remain the number one means by which fraud is detected and recommends that organizations implement hotlines to receive tips from both internal and external sources.

Internal controls

Financial management should establish a strong internal control process in day-to-day operations. The process should include both preventive controls and detective controls. Preventive controls are proactive controls designed to avoid an unintended event or result. Preventive controls would include the separation of duties related to cash receipts, cash disbursements and payroll processing, the authorization policies for disbursements and wire transfers, and other policies or procedures designed to ensure that only properly authorized transactions are completed. Smaller law firms in particular often have a significant control weakness when a few partners hire an office manager and depend on that individual for all finance related functions. For example, one law firm had an office manager working with them for 21 years who stole more than $800,000 during the last seven years of employment.

Detective controls are reactive controls designed to discover an unintended event or result. Detective controls would include procedures such as reconciliation of asset and liability accounts, and comparison of actual results with budgets to identify potential unexplained variances. Completion of bank reconciliations on at least a monthly basis by someone who is not responsible for preparing checks for disbursement is a critical detective control. This key control should be completed as soon as possible in order to detect a potential error or fraud involving cash. We worked with a large law firm whose accounting staff one year became too busy with other tasks and delayed completion of bank reconciliations. This large firm had a significant surprise during their year-end audit when an error of more than $500,000 was discovered that reduced net income and the reconciled cash balance. While this error was the result of accounting errors rather than fraud, it still resulted in a major surprise to partners whose income was substantially lower than expectations.

Fiscal management

Given the changes occurring in law firm business models regarding leverage, client fee arrangements, and the ebb and flow of demand for legal services, this is a particularly important time for strong fiscal management.

Financial managers need to keep a careful eye on operating trends to assist senior management with identifying opportunities for improvement and areas where corrective actions may be warranted. Financial reports should be accompanied by a summary analysis to assist senior management in efficiently drilling down to key issues and avoiding erroneous interpretation of results.

Cash flow management, with particular emphasis on the timely billing and collection of fees, is even more important with the growth of alternative fee arrangements. Most law firms have experienced greater realization challenges the last couple of years, which means that less of their work in process based on standard billable hours is being billed and collected from clients. As a result, more unfavorable surprises will occur when billing analysis begins to lag and what appears to be earned fees turns out to be a larger write-offs than expected.

Practice management

Practice management support is also becoming increasingly important for financial managers. The growth of alternative fee arrangements means that attorneys now face a heightened requirement to project estimated hours and costs for services, to reevaluate what portions of services can be performed by lower level professional staff, to negotiate creative financial arrangements with clients, and to develop and employ project management skills in order to effectively manage engagements. Each of these developing requirements indicate areas where the skills of financial managers can and should be utilized to assist attorneys and law firms navigate through this time of change.