Financial Health Check - Red Flags Every Law Firm Should Watch For

Welcome to Accountants Law Pod, where accounting professionals and law firms converge. Hosted by Lynda Artesani, Sarah Prevost, and Steven Libhart.

Welcome back to the podcast, everybody. How is everybody doing? I know Sarah and I are like traveling fools. How about you, Steve?

Just been working. We had 3 new client leads come in just yesterday, all in the same day. And so all of a sudden it's like, whoa, Jump on those. So you know what's involved with that. Yeah, it's just been busy, busy.

Don't do like me and Sarah do once in a while. We're like, oh, we really like this poor little small law firm. And then we're like, oh, we'll just, we'll just do it all for free. But we got the client. So we just, we just really like the person, you know, and somebody talked to us at the conference.

Hold on. Not for free. We're not doing it for free.

But you know what's so funny is that we talked to somebody, they asked about our client base and What client at our conference that we just came from and what kind of client is your perfect client and everything. And I pretty much answered it, like, explained that we love mid-sized firms, but once in a while a solo will come our way. And we just really, like, fell in love with this.

You bond with them. Yeah.

Yeah. And someone said, yeah, that's right. You just work with the clients that you love. And that's more important than, like, you know, size doesn't matter. I'm sorry. I'm always—

That kind of ties in with our subject today on red flags on our side of the fence.

Yeah, well, and you know, the thing is, so yes, financial health check, red flags every law firm should watch for is the topic. And you know, that's why you want to charge for your— like Sarah and I charge for consultation fee. I'm sure you do too. Charge for the clean, uh, to get the price out to them just to go through the file review. Because that gets rid of the people who are never gonna pay you what you wanted to get paid for.

Correct.

That's so important. And sometimes it's just, you really kind of bond with somebody like, oh, I don't think I wanna charge it. But you really should stand your ground and really charge for that. I think that client did pay us for the consultation, I think, but it was a very small firm. But he was so engaged and he wanted to, He was so eager to learn. Like, Sarah gave him like this massive lesson in our little meeting with him because it was like, oh, you need this, you need that. No, why don't you open up your file right here? And we kind of just went with it. But normally we don't do it that way. Yeah, yeah, a very strict process. But this was such a small client that— yeah, but he was really— he was sweet. So yeah.

So with the solo, because I teach this at the law firm, Or excuse me, at the Bar Association with the newbies, what kind of red flags do you think they should be looking for when they're looking for us?

Oh, they should be working with a bookkeeper and they don't understand the terminology in the law firm. That's going to be your trigger that it's— that person doesn't really know the industry. And not saying they can't learn it. We all have to learn it from somewhere. I remember my first law firm client. I didn't know anything and he was very open to working with me and teaching me, but also I had a reduced fee for him. So if you're looking to get someone like you don't have the time for that and you want someone that's going to know what you do for a living, I think you really need to find somebody. And it's probably going to cost you more because of the knowledge that we've all gleaned from all the work that we've done already. And that comes with a price because we are now going to make your life so much easier that it's worth it.

The small firms, the biggest thing I feel like is it's— there's so much time spent on managing the cases because it's you.

Yeah.

You need that support. So you really do actually need— it costs extra, but you should have someone more tenured, I feel, doing the work because they're going to be able to foresee anything coming your way. Like, there's going to be some issues that you may not know about, and that's not your forte. As a small firm owner.

If they have trust accounting and they're listening right now, go hop on your computer, look at QuickBooks, run a balance sheet, look at the bank balance, then collapse the client trust liability account if it's got subledgers. If not, if it's just one account, and see if those 2 numbers align. If they don't align, you gotta call us, right? Because that's a big red flag that the first place we kind of draw to. And I think also one of the things we do that you might find that that's something that you don't see is look at the— just look at the chart of accounts.

I—

that's always been like the place I see. If I see people's names on it or vendor names on it on the chart of accounts and the profit and loss side, that's usually a trigger to me that the person that was doing it doesn't really have an accounting background. We opened up a file not that long ago, and it— the numbering was only up to 4,000 on the chart of accounts, and we thought, Sarah noticed it right away. She's like, ooh, look at the numbers. And it was like only went up to $4,000. So that's your income account. So that's somebody who didn't know what they were doing because it only ran through the $4,000 all the way through. I don't know.

Well, the, the person actually has an accounting background.

They do. I know we found that out.

Interesting.

Yeah. But it could be—

that's—

I know you're just speaking to QuickBooks, but it could be any other software. It, it really You should have anything held in trust match, align with the bank account, or have the reasons why it doesn't. The other thing is the cost and expenses. Where are those going? Because you're incurring them on behalf of a client.

Also, that balance should align with your legal tech software. If you're using Clio, LeanLaw, PracticePanther, those numbers should match the numbers that the books say as well.

That's the 3 ways, the 3-way reconciliation.

Exactly.

Yeah. If you're in separate softwares too, some people are in the— but when you're— I feel Steve, and let me know because you've, you've taught on this, is I do feel that people who are just getting started out may not have elected a software yet or chose to go in one and they're partially in. And that doesn't really work because they're so scared they don't do anything.

Yeah, they don't do anything. And then they come to us and say, hey, I haven't done my books for 9 months. Can you have this done by next weekend?

I, I use the software Where are all the bills? Oh, that was like, you, you put all the money in, but what'd you attach it to? Did you record it as a bill?

Oh, so they hadn't, they hadn't entered their invoices?

No.

What, where were they? Where were they?

They're nowhere. You know, payment, the payment says how much is earned versus— I'm like, no, no, no, no, no. What's the point of software if we're not actually going to utilize it?

So they were billing somewhere else and—

Nah, I don't think so.

I think they just recorded payments.

They didn't just record payments.

You know, Clio lets you do that.

So did they say to their customer, you just owe me $5,000 and that was it with no bill?

And any, any software, any software lets you do that. It doesn't matter what software it is. Any software lets you do it. But okay, so, but what's the bifurcation of fees earned versus expenses? You can't just put it on a payment statement and tell me after the fact. You got to show their earnings, the revenue.

And I love that word, Sarah, by the way.

Which one?

Bifurcation.

Yeah.

I've just always loved that word.

Yeah.

Excuse me, I'm a frog today.

You do.

It's okay. To Lynda's point, though, I feel like what you do is you have gut checks. You have these places that you can validate whatever you're in. If you're in a spreadsheet, which we've often seen people do because you're smaller and it's just easy to track and you've just started out that way, but the question becomes, you're a law firm, is that how you're really going to look at people's trust accounts? You should be in a practice management software. You should have a proper ledger system. 90% of the time, you're probably set up as a firm that The entity structure dictates it needs to be in these structured systems. So—

So let me play devil's advocate here.

Okay.

How do you— going back to what you were talking about a minute ago, Lynda, how do you coach the red flag of the chart of accounts that has employee names and vendor names and all those things in it? How do you persuade them, or how do you give them a different tool? And what is that tool? To track those things?

Well, when you ask, and I've had this happen, so I've asked, I said, wow, but this person actually had all the trust on the profit and loss side. They were running P&L by client.

Man.

I asked why they were doing that and they said, well, I like to see it that way. And the same thing if somebody's got a lot of vendor names, like I've seen it where they have office supplies and then they'll sub it down Staples, OfficeMax, all of that. And I'm like, why are you doing that? And they said, well, I want to know how much I spent at Staples. As opposed to OfficeMax. And I'll tell them, like, there's reports you can run on that. You don't really want to see that on your profit and loss. And it's always curious to me because they'll have had that for years and they give their, you know, their documents to the tax person and the tax—

That was the next thing I was gonna say.

They don't see anything. They just must total it up and put it on. They don't bother. And it's like, yeah. And when I see employee names, on a profit and loss, like wages subbed down by Mary Smith and Joe Bananas or whatever. It's like, oh, you really don't want to have that on your, on your profit and loss. Because if you ever had to bring those, those records to a bank because you wanted to borrow money or for whatever reason, that's going to cause you some problems. You really want to have compliant books for many reasons, but you just want to have something. You don't want to be giving something to a bank that the bank's going to look and say, gosh, this is so bad. That how well is this firm run? Run it.

And that's a good point. The bank and the tax preparer both. And that's what I say to them. They're going to use this document, the P&L summary report. They're going to look at that and get their high-level look at what's going on. And if you water it down with all these extra subaccounts under people's names and vendors' names and all that, that makes them very nervous about what they're getting into.

Yep.

You know, Sarah's got that smile. What do you got to say there, Sarah?

Okay, we're talking small firms, but what about larger firms? What would you think, um, let's just say a mid-sized firm or a multi-partner firm, what would the red flags be for them? I mean, do you think about that? There's more complexity into those records. What do you think would be a red flag for a bigger firm? Obviously all the things in the smaller firm will apply too to the bigger firm, but what else do you think?

I think the KPIs, you know, the things they really want to track that we help them identify, the most important key performance indicators that mean something to them, they really need to take a look at that because for some reason they, you know, that's a hot button for them. And so that can be a red flag if those start to get away from you, you know, like your labor cost compared to revenue. Depending on the type of firm that you are, I mean, we've talked about this before. If it's personal injury, labor costs is going to look super high until settlements come in, things like that. But then if you're a, you know, a corporate attorney, you know, you pretty have a pretty steady cash flow usually coming in the door. So your KPI is going to look different. But really watching, I think one of the biggest red flags is the labor costs. Not to bemoan that people are making too much money. I don't think that That, that's the issue. But I think that watching what those expenses are compared to revenue so that you can tweak your hourly rates or your flat rates or however you run your law firm, you know, that really tells you when it's time to actually pass an increase on to your clients and how are you going to do it and all those sorts of things.

Mm-hmm.

Other, other red flags is when you, when you see productivity by employee changing for some reason, what's going on in the firm? What's happening in the background? Why, why, why is that number fluctuating the way it is? There's a lot of little red flags with labor costs that you can look at.

I see it more as, to your point on labor, is the unbilled time and the productivity. Yeah, yeah, yeah. And then the other parts to me is compliance complexity. If you have jurisdiction in different states, are you compliant with all of it?

Correctly?

Do you have employees? Employees are starting to crack down. I mean, states are starting to crack down more. So if you have basically basis there for some reason, what does that look like? The other biggest thing I see that Lynda and I both have actually seen quite a bit is the way advanced client cost is handled.

That's a huge red flag. I'm glad you brought that up.

Yeah, it's really, um, it's not that it's done incorrectly, it's that it's— it needs to be managed or double-checked, basically. Some people are really tight and have a good, you know, tight handle on it and do it very well, which is great. Um, but you, you can, if you're not managing it well, you can slip that up incorrectly.

Well, you know, one of the red flags I've seen in the cost receivable, the advanced claim costs, Is a negative will suddenly show up on that ledger for Joe Smith. And you're like, wait a minute, he's paid us money for something we never posted to that ledger. It could be a FedEx charge, you know, that, that somehow got on his bill.

Double paid.

Double paid.

Paid it out of the trust account, but then yet you said you incurred it on the other side. It— that goes back to the initial conversation, I think, about that 3-way reconciliation. There's ways Validate and make sure. Also, Lynda, you probably could speak to this really well. The uncleared items, deposits or checks.

That's a red flag that your bookkeeper is not doing their job. If you go and look at— ask to see the bank reconciliation statement and look at the uncleared. If you've got uncleared like 2016, things that go back that long that never— especially deposits. So it's always curious to me about the deposits that haven't cleared. that you've entered, but also uncleared checks, especially on the trust side. You really have to stay— part of compliance is making sure you stay on top of that, and then you have to return it to the state if you can't find the person. I think also with a bigger firm, you may have class coding because you're tracking each attorney, and that could be— pull that report up and see if there's undefined. Maybe there's a lot of stuff not being booked to a class. Also location. I mean, Sarah, we've seen that where the bigger firm will have They'll have an AR department, they'll have an AP department, and then things are tracked, but then they're not always tracked. Like, they put it in there even though it asks you. You can put bumpers on it and say that every transaction has to have a class or a location or they can't enter it, but then they can bypass that and then they bypass it. And I think too, it's so critical when you're working with these bigger firms because there's so much—

That's a great point.

working in it, right? You want to put boundaries in with dates being locking out a period so that you don't have that. But also payroll complexities. I mean, we could go on for about 5 hours about payroll and things that can go wrong with larger firms where you've got multiple people working. Same thing as the liability accounts. You got negative liabilities, you've got liabilities that don't make any sense when you look at the balance sheet. Those are red flags that your books might not be accurate. I mean, you could always Find somebody to have them just look at it. A third party.

Yeah.

Kind of look at it and just say, do these seem right? Like I said, gut feeling. If the gut's telling you it's not right, or you feel like— how many times we've had conversations with attorneys where they say, I know my trust isn't correct. That's how they start the conversation. And like, okay. And then like, how long have you felt that? Or when do you think it was last correct? I don't know. I just know it's not— it's bothering me. I can't sleep at night. And then you're there to help guide them through that part of it, because that is something that we hear often. Like, help me fix this because something's not right on this. I know it. I can feel it in my bones. And then there's a sense of relief after we fix it. I mean, it's expensive to fix a big mess. So if you feel that the mess isn't that big, get that fixed before you keep going on. It's so critical to have the right person doing the work, though.

The person that— the thing that we didn't bring up that gets overlooked quite a bit is, you know, that a paralegal is partitioned off into doing part of the work. And this is between a boutique-size firm to a mid-sized firm. You hear this all the time where you have someone who's an office manager that's finished up their law degree. Like, okay, great. That's great that they're in charge of finance. How do you bifurcate that into— how do you happen to be 2 people in one? For, for the firm, right?

Well, and have them be focused and have them be—

but who's overseeing it?

Right.

And to, to Linda, to your point, that's where we see these mistakes. They're not intentional, but you have nobody looking at this with that lens of, hey, I got a complaint, now I gotta handle it. But because maybe a bar complaint will come in, um, you, you just don't know. Or you have a disgruntled client, but How do you— how, how come it took 6 hours to dismantle the ledger to understand what happened? Shouldn't take— you know, there should be, at this moment of time where we are today, there should be a level of transparency of data. And we really wholeheartedly— I know the 3 of us work like this— we like a lot of stuff online for ease of access, for validation. Banks should be able to provide— if checks are still being written at a firm, we should be able to have that detail right there at our fingertips. It shouldn't be a locked thing for someone like an outside firm to validate. There's multiple ways in making sure, but it always does come back to— and that we have this in conversations, and I'm sure you do, Steve— where is this coming from? How do you know it's wrong? Well, why do you feel like something's off? It's always a spidey sense. We know it. We could easily say that today if we're looking at something, we're like, I don't think those hours match up to what we're getting billed.

Right. That's a big red flag. And then also, I think too, when you're looking, a lot of times I've written so many articles on advanced client costs and the proper methodology behind it and what the IRS says they want to see it as.

Yes.

A lot of times we get calls after I write those articles because they're looking at their records and they're going, I've got billable expenses and billable income and I need to shift it over to advanced client costs. That's where it should be. That's what the IRS wants to see it as. And then all of a sudden they're calling going, can you help me fix that? And then that's a dance of timing, right? Because you don't want to just strip it away, especially if they've had tax returns. And then you want to talk to the tax person because we've had that happen where we've asked the tax person like, this is a, this is a PI firm. They had a load of expenses and now they're gonna have a load of income coming in without expenses. How have you managed that? And then they'll tell you, oh, I don't always go by those numbers. I do this, this, and that to come up with the numbers. Like, well, has anybody tied the books to the tax return? There's another red flag. 90% of the time, more, maybe more like 99.9%, when a client comes to you, they've never tied their books to the tax return.

Yeah, they don't.

Once you've done that, it makes a whole difference on the records.

There's that whole thing too that we had most recently. An employee has a loan. On the 401.

Yeah.

Well, how has that ever been handled? How long? We, we are inheriting it. We're looking back through the records. It's incorrect.

It's incorrect.

So it's being incorrectly booked. And, and these are things that are the health of the file is basically what we were— all 3 of us were saying. It's the health of the file.

So I'm sure when your 401 account is negative, you know. Yeah. Or I'm told, and nobody's ever applied it. It's never been put in the right way, so it's not being entered properly and it's just growing. And then you're like, well, what's going on here?

It's happening. Yeah, yeah.

We always have.

You know, this, this makes me think about the medium and large firms. Quite often, you've probably seen this, have a managing partner.

I was just going to say.

Were you going to jump into that one? They have a managing partner, but they don't get to be a managing partner. They still want to be the lawyer producing hours, and they've got to have a division there and really be the expert at watching the business of the business.

Mm-hmm.

I call it the business of being, you know, you've got to be that person for your business in the law firm. And when you come across the ones that really are the managing partner, they know where their HR is, they know where their 401 is. They know what the financials are doing. I mean, have you guys seen that?

Oh yeah, I smile because it's, it's a position that some people gravitate to very well, right? It's for them. They do really well with it. They, they know how to manage it, but yet at the same token, they need the support around them.

Exactly. The whole firm has to support that.

Yeah, because it just— and, and it's just like the person bringing in this passion for marketing and bringing in the sales, you've got to trust that the people behind you are doing the rest of the work. So where it gets sticky is in any red flag moment like this, when you're looking at it, you can't— it's hard to separate yourself into all these buckets to be able to manage it. So where can you be? Where is most efficient for you? And for us to be able to say, look, here's the transparency behind it, here are the Facts behind it. We follow the money. This is what happened. This is how it's laying out. These are the corrections that need to happen. First off, the biggest thing I'd like to say is: Do you want to pay extra in taxes because you misrecorded everything? I don't think so.

Because sometimes, sometimes they're trying to save money and not pay. They look at us as overhead. But then if they actually look at The fact that we could save them money because maybe the person in that seat is recording invoices and payments and then deposits are being booked to legal fees here and you're doing it twice. Now you've got double income. Those are the things we've seen in files that we're like, oh my goodness, you just— you become the hero really quick when you go in and clean that up.

Or you find out that inadvertently they were never informed when a case had settled. That, yeah, this amount of money should have been transferred. They thought it had been transferred because they don't have a secondary person checking. And then we're the ones coming in going, we don't, we don't see this money moving anywhere.

Yeah.

Well, you know, more and more I find myself talking to attorneys about their workflow.

Yeah.

You know, and doing charts with them and And visually laying out the workflow for when this happens, do this, do that. And they're very grateful for that because they're like, oh, I didn't realize that. Let's say with these payment platforms, Confido, Gravity, you know, all that, there's a delay when the money comes into the bank. And yet it's booking it in the LeanLaw and the Clio and all of that as it sees it. but the money's not there in the bank yet. So the trust really isn't in balance. And you have that, that period of time where all that money is flowing back and forth. And if they're not keeping the person in the office on top of that, and if we're not staying on top of it, which we do, you know, it can get away from you very easily. And that's a huge red flag. And back to what you were talking about a minute ago, we just, we just were working on this massive Trust cleanup where they were double booking the income into legal fee income and they, they were taking chunks of money to cover their cash flow instead of allocating it to the clients properly. And it just was a huge spaghetti to undo. But that's, that's a massive red flag when that starts to happen. You know, the bus has to be stopped and everybody, it's all hands on deck and you've got to, you've got to fix it.

I think—

Why? Why did they not know? Why don't they know that that bill was finished? Because of their workflows.

Yeah, I think it comes down to— I'm grateful to our staff, Sarah. Our staff will say, I noticed the client is using this software or paying for the software, but I asked them how many users are in there and they're paying for 75 users and there's like 3 people using the product. That's when you really, you know, you have a good bookkeeping staff team, whatever. That they're looking for those things that will help you save money.

What I kind of think of it in a simple way, like Steve, to your point, you've got somebody answering the phone, servicing your clients, servicing you, and also having to separate out time to record payments. There's no time to oversee all of that if that's not their profession.

Correct.

So they might raise their hand and be like, yeah, no, I've got— I took a few accounting classes. God bless you. That's great. But that's not what you do every day.

Most of the time they go, oh, I really don't like doing it. But I had accounting in high school that, you know, I Google, I Google a lot to get the answers. It's like, oh, and they're nervous about it, especially anything that has to do with, like, taxes and anything like that. They get very nervous because it's not what they do.

Well, one of the biggest red flags in the law firm is if you just Don't see what you don't see. Yeah. Until the problem gets so big, it's okay to admit to us, the accounting side, what's behind door number 2 that you don't want everybody else to know about. At least tell us, because we're not going to judge. We're going to help you fix it. Well, but that should be a huge red flag. What's that?

We're business owners. We get it. We're right there with you without So we're in no position to judge. We're just in a position of service and support. Bottom line.

Sometimes they're embarrassed by it, but it's okay because, like you said, we don't know. Neither do they. So it's the same thing. I mean, it's a good time to stop and look if you're thinking that this is something that you're seeing inside your firm, or even if you work at a firm.

Or you're second-guessing yourself right now and you're like, okay, this has been a lot of good points.

Yeah, this is a good topic, Steve.

Well, thank you.

I love it.

Awesome.

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Great topic, Steve. I know you got more in, in, uh, in the can, so we'll see what the next—

But I got to make them harder.

No, no, no, this was a really good topic because I think there's a lot of attorneys out there that are like, Maybe questioning that they didn't— they're not sure if their records are right. And I think that this is a great topic or a segue to kind of have them look, give them places to look.

Another segue that we'll have to talk about is when you have too much on your chart of accounts, you are overdoing it. What is the detriment to that? So we'll have— so I'll add to yours.

Yeah, here, write that down. Until next time, it goes on.

Thank you.

Bye.