DEMOCRATIC SYSTEMS

The most common compensation systems are the democratic systems. One of these is the equal distribution system, in which all partners receive equal compensation regardless of their levels of effort or contribution to the firm. For example, Partner A has 1,600 chargeable hours and a good billing and collection record. Most of his work is done for long- standing clients of the firm. Partner B has 1,100 chargeable hours; she is a rainmaker and brings a good deal of work to the firm. Partner C has, 1,100 chargeable hours and devotes several hundred hours to practice management. Partner D has 1,300 chargeable hours and is the tax expert for the firm. Each partner is contributing something different to the firm, but all the contributions are meaningful.

Another common democratic system is the lock-step system. Groups of partners (usually in the same age group or with like experience) receive their initial compensation as partners and subsequent increases as a group. In other words, all within that group receive the same increase at the same time. For example, consider a firm that admitted two partners in 1969, three in 1984, five in 1985, seven in 1986 and three in 1988. The firm might have six groups, partners with the firm prior to 1984, and groups for 1984, 1986, and 1988. All of the partners within the various groups would be compensated identically.

In the seniority or longevity system, distribution is based upon how long the partner has been with the firm. For example, the longer a person has been with the firm, the more he or she earns. Many lock-step plans start phasing down particular groups at a certain age-for example, age 60-while seniority systems usually continue to increase compensation unrelated to the work being performed. The simple theory behind the seniority system is that "you pay your dues" for many years and then reap the rewards.

There are several advantages to the democratic systems. Internal competitiveness is held to a minimum, and partners do not spend time worrying or arguing over what they earn in relation to others of the same age and experience. Competition is directed outwardly rather than inwardly. Finally, the democratic systems promote the concept of the firm as opposed to the individuals. It is interesting to note that firms operating under democratic systems usually have good delegation and specialization characteristics as well as a team approach to client services.

However, for these systems to work, there are two important requirements for success. The firm must experience continued and unabated economic growth, and it must exercise great selectivity in partnership admissions

BUYING AND SELLING TIME

Buying and selling time is another common method found in CPA firms for dividing up compensation. Unlike the democratic systems, this method promotes individualism instead of institutionalization. Each professional is assigned an "inside" hourly rate and an outside" hourly rate. Various methods are used for charging overhead usage. Firms that are, in effect, space sharers might find this system useful.

When building a firm, however, this method has more disadvantages than advantages. One of the concerns, for example, is that partners tend to work only on what is profitable for them. Internal bargaining occurs when work has to be done. Client service is secondary, as the originating professional decides who will do the work, usually on the basis of potential profit to her or him rather than who will do the best job.

Buying and selling of time impedes departmentalization and specialization, and creates internal strife. This method also fails to recognize the time devoted to office governance and management with the result that these areas often are inadequately managed. Finally, this compensation approach often stifles the business developers in a firm; over the long run, a firm will lose such valuable people.

COMMITTEE APPROACH

Compensation committees are frequently used to divide profits among partners. Compensation committees sometimes have vague criteria and, in a few cases, no set criteria at all. The committee typically examines any objective data available and also considers some subjective factors in arriving at its determination of distribution. The executive committee of the firm often serves as the compensation committee. There is no best way to compose compensation committees, and many different systems are used.

The success of the committee usually depends on two major factors. It must clearly enunciate the criteria to be considered prior to distribution time, and it should make known whether particular factors are weighed more heavily than others.

Partners who are dissatisfied with a compensation committee's determinations typically complain that no one knows what the criteria are, or, more commonly, that the criteria change without notice. Partners want and are entitled to some say in compensation determinations. The committee should seek input from all partners regarding their own contribution and that of other partners. Many firms use questionnaires to do this, though a few firms require the committee to speak privately with each partner.

Benevolent Dictator

in younger firms, the managing-partner (or founding partner) often sets the compensation for all partners alone. This is simply a variant of the compensation committee approach. The managing partner tends to work in a "benevolent dictator" style. Typically, this partner started as a sole practitioner and built the firm him-or herself and tends to dominate the firm so other partners are comfortable following his or her lead.

POINT AND PERCENTAGE SYSTEMS

The point and percentage systems are an increasingly popular way to determine individual partner compensation and assist in determining income distribution. This is done under the theory that no one can argue with "objective" standards and that determining income in an objective manner is fairer," takes less time, and requires fewer individual judgments.

The most common formulas credit partners with some percentage of fees earned on matters they originate and the value of hours they bill. For example, a partner originates 250,000 of work in 1989 for which he or she is credited with 20%, or $50,000. In addition, 1,400 of the hours worked were billed to clients at an hourly rate of $120 per hour, or $168,000. The partner is credited with 80%, or $134,000. To the total of these factors ($218,000), an overhead factor, of, for example 10%, is applied. The adjusted amount of 196,200 is the basis on which the partner's income is determined.

One Way of Doing It

One of the oldest point and percentage systems is the Hale and Dorr System borrowed from the law firm of that name. In this formula a committee looks primarily at the objective factors of hours worked, origination and profitability, and then weighs them. The formula is applied to monies collected. A weight of six is applied to the work done (the workers' share), a weight of three for origination of the business, and a weight of one for the profit (to the originator). Approved management time and other work done for the firm is given the same weight of six as for the work done. The figures spanning several years are given consideration in order to arrive at a "fair" compensation for the partners.

Bring the Business In

Business origination is a variant of the point and percentage system. The partners are given credit on fees received, depending upon who originated the work. Thus, the partner who can say, "This is my client," obtains the credit. Deciding who originated the work is not always an easy matter.

Hours Billed or Hours Worked

A third point system used is the hours billed and/or hours worked system. In this method, the partner gets credit for the number of hours worked or for hours that have been billed. This would usually be from 50% to 80%.

A variation of this specifically awards points to the originator for using other partners, staff and paraprofessionals. On the other hand, some systems penalize the partner for using other partners, or, on the other extreme, for doing the work him-or herself

Variations on the Theme

Point and percentage systems vary greatly. Some firms append an additional credit to origination and hours. There might be a longevity credit or an office management and administration credit. Often there is some consideration for approved non-chargeable time, at partners' regular hourly rates, or perhaps calculated at a lesser rate. An increasing number of firms are using a composite of all of these point and percentage systems.

Now for the Problems

There are several potential problems with these formula systems. Foremost is that the formula systems do not properly measure the contribution each professional makes to the firm. The formula systems also foster "playing the numbers" and cause the partner to concentrate more on his or her own compensation than on what is good for the client or good for the firm. Also, seldom is the credit meaningful for management time, training associates, team spirit and attitude.

Point and percentage systems usually cause hoarding of clients, internal competition and under-utilization of partners. Most firms with very objective formula systems act like associations of CPAs in which each individual is more concerned with his or her clients and compensation than in the overall success of the firm. in short, such firms find themselves in the situation where "the tail is wagging the dog. "

The fallacy with most formula systems is not so much in how they actually divide profits, but rather in the effect they have on each partner's attitude towards the firm as a whole. These systems tend to de-emphasize leadership and may create a weak management structure. When a firm faces problems with a weak or non-producing CPA, it is easy to say, "Let the formula deal with it," rather than have the partners face the issue head-on. The eventual result of such an attitude is a weak firm with disgruntled partners.

By the Numbers

A serious fallacy is the belief by some that such a system is, indeed, objective. In truth, it may turn out to be less objective than a so- called "subjective system," because a formula system will invite manipulation in order to have the numbers "come out right." Typical of such manipulation would be the splitting of origination credits to encourage another partner to assist the originating partner in handling work.

In some situations, one partner max, have control over another by refusing to delegate work and thus, through the "objective formula," create a situation in which a partner's "numbers" look bad, eventually leading to a reduction in income. This is particularly true for those who specialize within the firm and depend heavily upon referrals from other partners.

Nor does the formula say to a partner, "The time you spend supervising, billing and directing other partners and associates is as valuable, whether billable or non-billable, as the time of a partner who seldom uses or trains others and who works, bills and collects for as many hours as are available." Obviously, today's economic realities require as much leveraging of staff time as is feasible for the firm. Thus, the point and percentage systems can defeat that purpose and, in the long run, result in lower income for all partners.

"ROUGH JUSTICE" SYSTEMS

The final type of system is the total contribution or rough justice system. This approach involves the use of a compensation committee (in a small firm, this may be all of the partners), a set of criteria to be considered, and in some firms a discretionary fund to be used in particular circumstances. In this system, the compensation committee works with a pre-defined set of criteria. This is not a contradiction of earlier comments relating to formula systems. Records of the economics of the practice and of the partners must be maintained and considered, but total contribution (past, present and anticipated for the future) cannot be computed by formula.

Many firms include the criteria in their partnership agreements, and the criteria are often broad and simple. For example, the criteria might include a review of the following: cooperation with other partners, quality and quantity of the professional work, leadership ability, dedication and efficiency, training and effective use of staff, ability to satisfy and bring clients continually back to the firm, ability to attract new clients, attitude and cooperation in dealing with problems, and historical contributions.

Rough justice systems usually involve several tiers of compensation. For simplicity's sake, three tiers will be discussed, although a firm may have more or less depending upon the size of the partnership and the particular needs of the firm.

Tiers One and Two

In tier one, each partner receives a fixed monthly draw representing the first level of income distribution, The draw will apply against the partner's participation in the profits as determined under tiers one and two. The draws should not be considered as expenses in determining profits and losses. Normally, firms should not set salaries exceeding 70% to 80% of each partner's prior year total compensation, excluding pension and profit-sharing contributions.

Net profits or losses in tiers one and two will be shared among the partners on the basis of units of participation. Annually (or less often) each partner will be allocated a certain number of units determined by the compensation committee. The committee will consider the criteria outlined previously. It will not be necessary to adjust the units of participation when a new partner is admitted; the new partner is simply assigned a number of units. Units are easily translated to percentages, but percentages require change when partners are admitted or depart, except in unusual circumstances such as gradual retirement. A partner's unit should not decrease. A firm might also consider a maximum number of units for each partner, say 100. Each partner's share in the firm's net profit or loss will be in direct proportion to the ratio of his or her units to the total number of units of all partners. Should a partner's draw and periodic distributions during the year exceed his or her interest in the year's profits, he or she will be charged for the deficiency during the next fiscal year.

The Third Tier

A third tier may be used for one of two purposes. Some firms will budget for a fixed dollar amount of profit. Anything achieved beyond this during the year may be split equally among all partners. An alternative approach is to use the amounts in the third tier to reward unusual performance, seniority, an extraordinary fee, or other significant contribution. This tier tends to focus upon an unusual occurrence in that one year, whereas the first two tiers look at a broader contribution over two to five years; the exact number of years varies from firm to firm.

In the rough justice approach to compensation, each partner receives a fixed monthly draw. Additional distributions are typically made on a quarterly basis usually for income tax purposes. All calculations are against net income, with a hold-back reserve determined by the partners. The compensation committee usually spends some time getting input from each partner before setting points.

CRITERIA FOR SETTING COMPENSATION

The five types of compensation systems (democratic, buying and selling of time, compensation committee approach, point and percentage, and total contribution, or rough justice) are the most commonly found methods for setting partner compensation. Each system requires the use of criteria for measuring performance.

There are more than a dozen criteria, the most popular being based on objective data. Objective data include several years' history of billable hours, billings, collections, aged accounts receivable, aged work-in-process, write-offs, realization rates, and non-billable hours by approved categories. As noted earlier, the objective criteria should not be the sole consideration, and in some cases, may not be prime determinants. The heavier producers, obviously, will be compensated more hand-somely.

Some criteria may appear to be objective, but, quite to the contrary, are difficult to quantify. Client development, as an example, includes client retention and development of existing clients. A partner must be able and willing to accept and successfully discharge primary and working responsibility for individual clients, including necessary client contacts and supervision of junior partners, professional staff and paraprofessionals. These attributes are not readily quantifiable.

Another example of criteria that may be difficult to measure, is getting new business, whether from new clients or from existing clients. This is critical for the firm's continued well-being and growth, This trait is hard to measure objectively, since it may be impossible to know exactly why a client actually comes to the firm. However, by being aware of what partners are doing and by discussing new work, the firm can keep informed of the true source of the new business.

Productivity Measurement

Another criterion is productivity, that is, hours worked and fees billed and collected. Defining the productivity of a professional is more complex than simply looking at computer-generated numbers. Productivity is a product of income generated, the hours the partner works, the efficiency with which the partner handles the work, the number of matters the partner handles, and income generated through work with other professionals in the firm. It includes the value" of the time worked and delegated to others-the condition of the partner's accounts receivable and work-in-process inventory; generating fees in excess of standard time; ability, to work independently; and the extent to which the partner utilizes firm resources. Of special significance is the existence of the multiplier effect-whether the partner's efforts extend to others by spreading business or supervising and guiding them. The priority consideration is dollars generated, not hours posted.

Additionally, it is expected that each partner will be "on duty" and attending to the business of the firm either through work on client matters or pursuing appropriate non-billable activities, for at least an agreed upon amount of time. The partner should be expected to be accessible during normal office hours.

Firm Policies

Special emphasis should be placed on the team concept and demonstrated willingness to abide by the policies of the firm, including requirements to keep time accurately and to turn in time sheets promptly. It also includes introducing clients to other partners, turning over client management and other controls to others when appropriate, and contributing to the equitable and efficient distribution of work assignments and client contacts. Further, this includes specializing and developing expertise in particular areas to complement other abilities in the firm. The partner should also be willing to abide by policy decisions of the firm and uniform procedures in billing and handling matters.

Quality

Quality, in its broadest sense, incorporates efficiency, diligence, timeliness in handling work-be it client work, firm management or business development. Quality includes a knowledge of applicable laws and accounting pronouncements; imagination, creativity and innovation; ability to write clearly and persuasively; ability to analyze quickly and accurately; good judgment; ability to plan and implement legal strategies; oral communication skills; and the ability to handle the unexpected. Some firms also include the ability to negotiate.

A partner must be willing to delegate work horizontally or vertically to ensure that the work is done when it is promised to the client.

Participating in Firm Management

Firm management involves assuming responsibility for the firm's long- term success. This includes overall business management, practice management, recruiting, and marketing. A partner with management responsibilities must regard that work as equally as important as client work. The firm should expect that advanced standing in the firm will bring an increasing level of contribution to the firm's success and growth through commitment and effective leadership.

Some firms consider personal relationships and teamwork as an additional management criterion in setting compensation. This goes beyond simply participating in and cooperating with the firm's committees, client sharing and introduction. It includes promoting harmony and good will among firm members.

Active participation in firm activities is frequently overlooked. This includes attendance at firm social and professional meetings, participation in management decisions and activities, and recruitment.

Other Criteria

Professional and Community Activities. Most firms, large and small, have long recognized the need for professional and community activities and include it as a compensation guideline. Contributions that enhance the firm's image and prestige through the maintenance of good relations with other CPAS, involvement in CPE programs, publishing, participating in professional activities, and assuming leadership roles in professional, civic and charitable organizations in the community contribute significantly to client development.

Professional Development. Professional development and delegation of work is also important. Time and effort spent working with younger accountants will increase their professional skills. Sharing work and delegating the work to others ensures benefits to both the client and the firm. Partners who are generally the most profitable to the firm are those who generate work or supervise the work of others-those who have the multiplier effect. They are especially profitable to the firm when the work is delegated to the lowest levels possible and supervised by the signing partner or manager.

Original Work. A few firms factor in the generation of original contributions. This may be an idea for a book, a program, a CPE course, or a marketing program.

Seniority. The consistency of the CPA's value to the firm over the years and his or her contribution to the firm's growth and success is a criterion in setting compensation for most firms. Note that seniority is not a factor of age alone, nor is it only the number of years a CPA has been with the firm. Rather, it means the number of years the partner has spent developing and maintaining clients and building and enhancing the firm's reputation.

Not all firms include all of these criteria. Nor do all firms weigh these criteria in the same manner or ratios. Compensation criteria evolve over time.

EVOLUTION OF COMPENSATION SYSTEMS AND CRITERIA

People and firms do not stay static; as people change or the character of the firm changes, the compensation system and criteria must change. Changes in economic conditions can impact the effectiveness of a system. For example, obtaining audit engagements has become far more competitive, and, in some cases, bidding wars have taken their toll on profit margins. The fee pressures have caused firms to look at their mix of work, seek cross-selling opportunities, and use the compensation system to focus activities of their partners on practice opportunities. Rapid growth, another aspect of the dynamic environment, will often dissipate the camaraderie that the founding partners enjoyed.

This is not meant to encourage constant change and meddling with the compensation system. In fact, compensation systems and criteria should occur no more frequently than every three years.

Bonus Pools

Some firms utilize bonus pools and "adjustment pools" to provide a dynamic element without changing the compensation system or criteria. Bonus pools are typically the top criteria in a point and percentage system. Similar arrangements can be added to the other systems. Adjustment pools, used in prospective systems, are typically far smaller than bonus pools and simply allow for a slight year-end adjustment when a partner has exceeded expectations.

Firms also evolve through several stages. very small practices have a tendency to keep things simple and egalitarian. Medium-sized firms and those firms in a fast growth mode tend to emphasize criteria and compensation systems that promote growth. Large firms in the top tiers have the problem that management cannot know every partner personally. Therefore, their compensation systems rely more on objective data and tend to emphasize institutionalization of clients.

Prospective or Retrospective

An increasing number of medium-sized and large firms are moving from a retrospective system to a prospective system. A retrospective system divides up profits after the fact, that is, at year end. A prospective system will set units or points or, in some cases, dollar amounts, at the beginning of the year. If it is fixed, each partner can readily calculate his or her percentage of the total profit and, therefore, will tend to focus his or her attention upon increasing the total pie rather than changing the size of the individual slices.

Compensation systems and criteria tend to change over time because there is no single "correct" system. No one system will fit all firms or satisfy the needs of any single firm throughout its evolution. Therefore, partners should examine closely the criteria they wish to promote and emphasize those characteristics in their compensation systems. it may be helpful to get an objective outside opinion before changing the firm's compensation system, or at least to assign several partners to attempt to look at it objectively.

The cross-reference chart included with this article helps to put all these factors and compensation systems in perspective. The chart should assist in determining whether a compensation system for a firm is the most effective and efficient given the character or culture of the firm. The most effective compensation system and criteria for a firm is the model that most closely fits a particular firm's present culture, goals, and aspirations of the partners.