Count me among the skeptics.
We are all familiar with the allegations that CEOs of publicly traded companies manipulating their earnings from period to period by such actions as booking discretionary expenses at the end of a strong quarter or deferring a major sale until the beginning of a new period. No one thinks that these actions are laudable from an integrity standpoint, and sometimes they are sufficiently flagrant to result in securities-fraud allegations.
Thus, it is surprising to me that law firm managers have been boasting in the first quarter of 2021 about their prudence in prepaying in the last quarter of 2020 major expenses that were not due until 2021. See, e.g., Andrew Mahoney, “Big Firms Headed Off ‘Great Unknowns’ by Pre-Paying Bills,” Law.com, Mar. 10, 2021 (discussing prevalence of practice).
I submit that this practice by the firms of Big Law has more to do with bolstering their public images than saving for a rainy day and is, therefore, just as sinister as income manipulation by publicly held companies. Cf. Stephen Fishman, “Deducting Prepaid Expenses under the Cash Basis Method,” Lawyers.com, Oct. 23, 2018 (discussing when it’s permissible to prepay expenses under cash-basis accounting).
Most law firms follow cash-basis accounting rather than accrual accounting. The big difference is that cash-basis accounting follows the cash—if you do not receive payment, you do not record the income; if you do not pay a bill, you do not record the expense. This inevitably tempts the managers of cash-basis businesses to game their results by timing their payment of expenses and, to a lesser extent, their receipt of income in order to make an accounting period look better.
Accrual accounting provides a more accurate view of a company’s performance by matching up income and expenses with the respective periods to which they relate. For example, if a company owes rent of $50,000 in every month for 12 months, the income statement will reflect an expense of $50,000 per month. This is the case irrespective of whether the tenant doubles-up its payments in one month or skips a payment in a later month following an earlier prepayment.
The distortion that can result from cash-basis accounting is generally not a problem. The tax laws require larger businesses to use accrual accounting, and with smaller companies, the owners generally are more aware of what is going on. However, the tax laws permit personal-service firms of any size to use cash-basis accounting. This is likely due to the organization of most professional firms historically as partnerships, which are “pass-through” entities for tax purposes (i.e., the entities themselves do not pay any income taxes but their taxable income is allocated among the owners for income tax purposes).
There are many firms in Big Law that are more like publicly held companies than family-owned or other privately-held businesses. Having been a partner myself at one of these law firms for many years, including over a decade in senior management, I am confident that the overwhelming majority of Big Law partners have very little working knowledge of their firm’s financial operations.
Big firms have a number of opportunities for timing their expenses in order to make a mediocre year look better or to shift part of the exuberance of a great year into the succeeding year. For example:
- Prepayment of rent: The easiest route in a very strong year is to prepay rent for the next year. Depending on the terms of a particular lease, it may also be worth deferring December rent in a weak year and then paying double rent on January 1.
- Timing of bonuses: Most firms pay out huge amounts to their associates and other employees as bonuses at the end of December every year, but a lackluster year could quickly become a good year by deferring payment of the bonuses just one day until January 1 of the next year.
- Employee benefit plans: Firms can also often make their contributions to employee benefit plans at any time during a multi-month period. This provides another significant opportunity for income management when the eligible payment period includes the last day of one fiscal year and the first day of the next fiscal year. (For example, clever managers could gain more flexibility by negotiating payment dates for major obligations that coincide with the end of their fiscal years.)
A logical question with respect to income manipulation in Big Law is “so what?” Many of the investors in publicly held companies may need protection more than the well-compensated partners in Big Law. It is useful to consider why the firms of Big Law are so anxious to trumpet their earnings every year—can you think of any other group of privately held companies that releases its performance data? One of the most painful steps for a company doing an IPO is publishing for the first time its earnings for review by its customers and competitors, as well as its potential investors. Why are we doing it?
As a former manager of a huge law firm, I recall floating the idea that we should simply not release our data in the annual American Lawyer sweepstakes. I also observed that some firms may consciously understate their earnings in order to look less piggish to their clients. My fellow managers never thought that I was serious because most partners believed that publishing consistently strong profit numbers was absolutely essential to attracting lateral partners.
Assuming that getting noticed by lateral-partner candidates is the justification for sharing otherwise sensitive, private information, it appears that manipulating income to mislead the lawyers who may join a firm is not an activity to celebrate, at least not publicly. Saying to a prospective partner that “our income has gone up every year’ seems a lot like telling investors that a company’s earnings per share always increase. Success is great when it is earned, but certainly not when it’s manufactured.
In addition, partners leaving firms due to retirements or other reasons inevitably receive lower incomes in their final years as partners when their firms reduce income by prepaying expenses. They will not be partners in the next year when the then-partners get a windfall from current-year expenses being booked in the previous year. In reverse, new partners—whether from lateral entry or promotion—get a free ride for prepaid expenses on the backs of the partners who left in the earlier year.
There would be numerous issues to debate if all personal-service firms were required to use accrual accounting, such as partners having to pay tax on income allocations that exceeded the cash distributions that they received. However, Big Law’s manipulation of income would likely decrease if the American Lawyer added questions about income and expense recognition to their annual questionnaire about performance data.
Lawyers in BigLaw are proximate to a lot of the controversies that surround large and powerful businesses—it’s the nature of our work. Thus, we have a unique opportunity to observe what matters over the long haul. Why not apply these observations to our business? Suffice to say, we can afford it.