Keep fraud out of your law firm

As counterintuitive as it may seem, law firms aren’t immune to criminal activity. Because some firms place enormous pressure on attorneys to produce billable work, they may be particularly vulnerable to fraud. Your firm needs to know what to look for and how to protect itself from potential schemes perpetrated by partners, associates and support staff.

Hold everyone to high standards

A firm’s accounting department — payroll and accounts payable and receivable — is where fraud often occurs. But even trusted partners should adhere to your firm’s internal controls and fraud-prevention processes.

All prospective employees, regardless of level, need to complete an employment application with written authorization permitting your firm to verify information provided. Then, call references and conduct background checks (or hire a service to do it). These checks search criminal and court records, pull applicants’ credit reports and driving records, and verify their Social Security numbers.

Protect with oversight

The design of financial documents can help protect your firm’s financial transactions from fraud. For example, use prenumbered payment vouchers that a designated partner must approve. This is effective because the designated partner knows what the transactions are and how they pertain to your firm’s clients.

A designated partner should also open all bank statements. Even if the partner doesn’t review every item individually, employees will get the message that transactions will be verified. Someone outside your firm’s accounting department, such as your CPA, might review transactions as they’re processed and financial statements at the close of accounting cycle reconciliations.

To prevent fraudsters from manipulating financial records, ensure that accounting and billing systems are accessible only to those partners, managers and accounting staffers who need to use them. Change difficult passwords frequently and keep your firm’s cybersecurity software current.

Special risks

Some smaller firms assign the same person to open mail, make bank deposits, record book entries and reconcile monthly bank statements. In this environment, fraud is not only possible — it’s likely. It’s critical that your firm distribute these tasks to two or more people. If this is impossible, consider outsourcing at least some accounting functions.

Firms of all size — and, in fact, professional service firms in general — need to be especially wary of expense report fraud. A manager should review all expense submissions before they go to accounting for payment. Require backup documentation and an explanation of how expenses relate to client or firm business.

Ethical culture

In the collegial environment of the typical law firm, partners and employees are more likely to be influenced by their peers. Make sure you’ve built a highly ethical culture in which everyone works to deter fraud and is committed to reporting behavior that violates policies. Contact us for help developing effective internal controls or if you suspect fraudulent activity in your firm. 

© 2021 Covenant CPA

Most companies wouldn’t go into business without some basic types of insurance in place, such as property coverage and a liability policy. For a company with more than one owner, there’s an additional type of risk-management arrangement that needs to be established: a buy-sell agreement.

If your business has yet to create one, you should start the process as soon as possible. A conflict over ownership change can distract a company at the very least — and devastate it at worst. But, even if you have a buy-sell in place, there are a couple key elements to regularly review: funding and valuation.

Evaluate your funding

For many businesses, payouts for a buy-sell agreement are funded with a cash-value life insurance policy or a disability buyout insurance policy. There are two main types of life insurance-funded buy-sell agreements:

1. Cross-purchase agreement. Co-owners buy insurance policies on each other, using the proceeds to buy a deceased or disabled party’s ownership shares. They receive a step-up in cost basis that may reduce taxes if the business is later sold. This option is usually preferable if there are three or fewer business co-owners.

2. Entity purchase agreement. The business entity buys insurance policies on each co-owner and uses the proceeds to buy a deceased or disabled owner’s shares, which are divided among the remaining parties. Co-owners receive no step-up in cost basis with an entity purchase agreement. This option is usually preferable if there are four or more owners, because it eliminates the need for each one to buy so many insurance policies.

Engage a valuator

It’s usually wise to hire a professional appraiser to perform a business valuation when drafting a buy-sell agreement. The valuation should then be updated periodically as circumstances that could affect the value of the company change. In fact, the buy-sell agreement itself should be reviewed by each co-owner from time to time to make sure it still reflects everyone’s intentions.

One specific issue to consider is how the “standard” of value is defined. A business valuation expert can provide definitions for a variety of relevant standards — including fair market value, fair value, book value and investment value. Different triggering events or departing shareholders may require different levels or standards of value.

Customize your agreement

Having a standard, boilerplate buy-sell agreement can be just as dangerous as not having one at all because its provisions may cause confusion or trigger disputes. Yours should be a customized, living document that provides a clear mechanism for equitable ownership change. Our firm can help you review the agreement you have in place or create one if you have yet to do so.

© 2020 Covenant CPA