I hope you have recovered from the migraine I inadvertently induced while trying to respond to your question last week. I thought it best to try again, this time in writing. Your question to me was: “Why does the firm’s 12/31/2011 balance sheet show a negative number for [your] Capital Account?”

[Keeping it simple.] In a partnership, a partners’ Capital Account works as follows:
1. Last year’s year-end Capital Account balance; plus
2. Cash or fair value of property contributed by the partner to the firm during the year; plus
3. The partner’s share of the firm’s net income for the year; minus
4. Total distributions the partner received during the year in the form of: (i) draws; (ii) draw equivalents (e.g., insurance premiums and profit-sharing/401k contributions funded by the firm on the partner’s behalf); and (iii) fair value of property or capital, if any, returned by the firm to the partner; equals
5. Capital Account balance at of the end of the current year.

If a partner’s Capital Account balance is negative, it means the partner’s aggregate distributions over time exceed (a) the amount of the partner’s initial and subsequent capital contribution plus (b) the partner’s share of net income accumulated during the partner’s tenure.

How is this possible? Debt makes it possible.

At the end of 2011, instead of paying-off the firm’s bank line of credit and reserving cash for the 2011 profit sharing liability, the Management Committee paid bonuses to partners on December 31st. In other words, a sizable amount of the firm’s 12/31/2011 cash in the bank went into the partners’ pockets, rather than paying down liabilities.

This raises the question as to how the firm will deal with those 12/31 liabilities when they come due.
· Our loan agreement with Big Bucks Bank & Trust requires us to have a zero borrowing balance for any 30 consecutive days each year.
· We can postpone funding the 2011 profit sharing plan liability until September 15, 2012, should we want to wait that long. As in prior years, we will extend the due date of the firm’s 2011 tax return until September 15th. The profit sharing liability must be funded in full before the firm’s tax return is filed, if the firm wishes to take the profit-sharing expense as a tax deduction for 2011.

Last December I explained to the Management Committee, the 2012 Budget anticipates generating sufficient cash to payoff both liabilities no later than end of July 2012. We paid the bank line of credit down to zero on May 1st and did not borrow again until July 16th. On July 16th, the firm tapped the line of credit again to help fund 2011 profit sharing contribution.

Negative Capital Account balances are considered, by some, an indication the law firm is aggressively managing its cash resources. Negative balances are seldom found in large law firms. They are uncommon in smaller law firms, but I am aware of several firms who, like PSRG, report negative Capital Account balances at year-end.[i]

Whether a law firm should maximize partner distributions – which is likely to produce negative Capital Account balances – must be tempered by firm liquidity considerations. High partner draws are contraindicated if the firm runs the risk of cash shortfalls to meet its routine monthly cash requirements for payroll, operating expenses and client cost advances.

I hope this explanation is more transparent and less physically painful than my earlier attempt. Esoteric financial precepts, like this, are not easily explained to non-accountants. They are closely guarded concepts accountants employ to ensure job security.

All the best, Mike

[i] Negative Capital Account balances usually come at a cost. Postponing payoff of bank debt in favor of additional partner distributions means the firm will incur interest expenses otherwise avoidable if the distributions were delayed. Similarly, once the actuary completes its testing of the profit sharing calculations, any funding delay will f result in loss of tax-deferred investment earnings inside the plan in an “up market.”