Realization Rate Losses: The Invisible Expense
In the first blog of this series, I gave the example of a law firm with 95.0% fee billing realization rate, 92.6% collection realization, and $5,000,000 of fee revenue. I took you through the math and illustrated how this firm would need to convert $5,682,000 in fee value from unbilled time into $5,398,000 of invoice fee value, to net $5,000,000 in fee revenue. Along the way, the law firm would experience fee billing losses of $284,000 and fee collection losses of $398,000, for a total of $682,000 of fee discounting along the way. However, don’t look for realization losses on the income statement—you won’t find it there.
Understanding Realization Losses in Law Firm Billing
Realization losses do not appear as an expense on the income statement. This is because most law firms report their earnings on a modified cash basis of accounting. With the cash basis of accounting, revenue is not recognized until it is received for services rendered, and expenses are recognized when they are paid. (Cash basis law firm accounting is usually modified to recognize depreciation expense and accrue certain 401k/pension related liabilities to mirror the firm’s tax reporting.) Realization losses are not recognized as an expense under the modified cash basis accounting rules, because, as tax folks say, it has “no basis,” meaning that the firm won’t be reporting a fee revenue of $5,682,000, so it is not entitled to a $682,000 expense. For cash basis (and tax basis) law office accounting purposes, the $682,000 simply does not exist.
Notwithstanding the basic accounting precepts, the $682,000 realization loss has a very real economic sense. The firm spent economic resources, such as lawyer compensation, staff salaries, and rent to perform that legal work but received no remuneration in return. Or think of it in these terms: What if the firm’s realization rate was 100%, except for one client that the firm performed $682,000 of worked for free every year? That situation would get everyone’s attention. However, the point is whether the $682,000 realization losses are the result of one client or many, it’s still a big number in the context of a law firm with total fee revenue of $5 million.
How Legal Bookkeepers Can Manage Realization
In my second blog post in this series, I gave an example of how a new billing partner unwittingly transformed “Mega Corp” from a $1,000,000-a-year client into a $729,000-a-year client through a series of misguided law firm financial management decisions. That was one example, but realization losses may take many other forms.
- Timekeeping Adjustments. Timekeepers often fail to record the actual time incurred to complete client billable tasks. Such practices are impossible to quantify because not all of the legal billing data is captured. However, there are things managers can do to combat unnecessary timekeeping adjustments. Billable hours should be recorded contemporaneously with the work — and sloppy timekeeping habits should not be tolerated. Young lawyers need to be trained early on to record all of their time. They should also understand that learning curve write-downs of their time are expected and their hourly rates are set with the expectation that they will not be as efficient as more experienced lawyers. Similarly, more experienced lawyers also need to be reminded not to substitute their own perceptions of efficiency for the billing attorney’s judgment; there may be other factors at play resulting in the client having a different set of expectations.
- Prebill review/edit discounts. The process whereby prebill fees are converted to invoice fees typically is where the largest volume of realization rate losses arises. The causes range from the billing attorneys’ perceptions that some of the work was not performed efficiently, to the client not appreciating the full value of the time worked, to running afoul of matter budget caps or billing guideline infringements. Every law firm should have policies governing the processing of legal billing discounts, including limits on individual billing attorneys’ authority to discount above certain dollar or percentage amounts without a second partner’s review and approval. The policies should also address how billing adjustments should be reflected in the accounting records specifying situations where allocated among timekeepers—e.g., specific time entry basis; pro-rata reductions based on proportional time value; and full allocation against the billing partner’s time.
- Write-down of Receivables. A client does not always pay full value on every invoice. It is not uncommon to have to deal with client requests for adjustments or accommodation. There are proactive steps that billing attorneys or legal bookkeepers can take to reduce collection realization losses. If a budget was set for the matter, discuss changes in scope as they occur and update the plan and budget periodically and get the client’s consent. If the amount is likely to exceed the client’s expectations, a conversation with the client is recommended before sending the invoice. Many firms encourage billing attorneys to show billing adjustments on the face of the invoice to defuse possible requests for further reductions. It is also recommended the firm have a policy requiring oversight/approval for invoice write-downs and write-offs above a certain dollar amount or percentage.
The best thing your firm can do as a law firm CFO to combat realization losses is to track and report numbers. Law firm billing realization and collection realization statistics are every bit as important as reporting billable hours, billing and collections on a monthly and year-to-date basis. Reporting raises awareness of the topic and will signal the need for remedial action when the numbers get out-of-whack. (More on reporting in the next blog entry in this series.)
What’s the Right Realization Rate Target for my Firm?
When I was working in Am Law 100 firms, my rule of thumb was 95.0% fee billing realization and 95.0% fee collection realization, a combined 90.25%. Recent statistics from the Am Law 100 firms suggest overall realization has slipped since 2008 to roughly 87%. There is no single right answer. It depends upon the nature of your practice, your billing rate strategy, efficiency factors, and other variables.
- Insurance defense firms tend to have higher realization rates—fee billing realization at 97+% and fee collection realization at 98+%. Factors that contribute to these high realization rates include:
- Rates being set by strict client billing guidelines
- Lawyers receiving extensive training from the firms to ensure their timekeeping conforms to requirements set forth in the billing guidelines
- E-billing invoice submission requirements that are strictly observed and appeals promptly submitted
- Corporate litigation, business law and general practice firms tend to have lower billing realization rates.
- Firms who engage in alternative fee arrangements or adopt fee discount strategies tend to set hourly rates higher with the expectation of lower realization.
- Firms with high realization rates may want to reconsider whether they have set their rates high enough and are not undercharging for the value of their services.
Billing Realization: Words of Advice
I believe the “right” realization percentage for your firm is probably the number you currently have. So, focus on how to improve that number by managing for an improved bottom line moving forward. My advice:
- Analyze your fee billing realization and fee collection realization for the last three years.
- Understand the factors that contributed to your past and current billing realization numbers.
- Set a fee billing realization budget and fee collection realization budget for the year.
- Employ measures as appropriate to address excessive discounts whether they arise in the timekeeping, billing or collection processes.
- Write a firm policy setting limits on write-offs without a secondary review.
- Report realization data monthly and talk about the numbers with your managing partner(s).
- Manage your way to higher profitability—all you need do is try.
Interested in Learning More About Law Firm Billing?
In the final part of this four-part series, we’ll talk more about realization rates, law firm accounting software, and more. Subscribe to the 4L blog today to ensure you don’t miss this next installment and be sure to follow us on LinkedIn.