Begin a conversation with an attorney about legal accounting and watch the color slowly drain from his or her face. Ask the office manager or staff person about client trust funds and wait patiently as the person hesitatingly formulates an answer. As consultants, we anticipate calls about software – how to run custom reports, how to fix a transaction, how to reconcile the bank statement. We also field and answer questions about process. When working with law firms, however, the questions are often more complex and urgent. Accounting tasks require handling with due diligence in an ocean of compliance.
Accounting for law firms is significantly more complicated than for other small businesses. Frequently the person on the other end of the call is frustrated, sometimes even frightened. The bookkeeping and accounting needs go beyond profit and loss and cash flow, and beyond billing and collections. In addition to business accounting there are two unique and required functions for successful legal accounting:
- Client funds/trust accounting, and
- Matter cost accounting.
These topics are not part of most bookkeeping curricula.
Additionally, one key to understanding the importance of proper law firm accounting is compliance. For attorneys, failure to remain compliant with fiduciary regulations could result in stiff penalties, even disbarment. Trust accounting and matter cost accounting can overwhelm even the most experienced bookkeeper.
Client Funds/Trust Accounting
Most law firms use retainers to secure cash flow while working on a matter for a client. These funds do not belong to the law firm until they are earned. Law firms may also hold funds for the benefit of the client, such as escrow for real estate transactions or personal injury settlement funds. Both of these are designated as current liabilities on the Chart of Accounts. Client funds held “in trust” should not be comingled with other clients’ monies or the firm’s operating funds.
This requires diligent bookkeeping practices. Overdrawing an individual client’s account – even using uncollected funds – means the firm is using another client’s funds. Improper accounting and failure to secure client funds is the leading cause of disbarment. Individual State Bar associations regulate compliance and states conduct IOLTA (trust account) audits. For the latter, providing copies of monthly three-way reconciliation reports can be the difference between a successful – and less stressful – audit and one that is not.
Figure 1 shows a warning when a transaction, in this case an invoice payment from the retainer, will create a negative client balance.
Figure 1. Illustration from Law Firm Accounting Demystified
Figure 2 provides the three-way reconciliation showing that the book balance, bank balance, and client ledger balance reconcile with each other.
Figure 2. Illustration from Law Firm Accounting Demystified
Figure 2 (Continued). Illustration from Law Firm Accounting Demystified
Matter Cost Accounting
Law firms commonly advance expenses on behalf of the client that may subsequently be reimbursed. These can either be designated as current assets (advanced client costs) or expenses (reimbursable client costs). The decision on which approach to use is dependent upon several variables, e.g., practice area, state regulations, accountant preferences, and so is not covered this article.
Managing matter costs requires contemporaneous posting to the matter to ensure the cost is recovered. There are three types of matter costs tracked by law firms:
- “Hard” costs are expenses for which the firm has disbursed its own funds for costs such as filing fees or medical reports.
- “Soft” costs are incorporated into the firm’s general expenses, such as photocopies or general postage. Many firms do not adequately track and bill these expenses, which results in “leakage” of revenue for the firm. When bills are paid liabilities and costs must be recovered before fees. If the firm is using the liability account, the payment reduces the liability. If the firm is using the expense account, payment should be tracked separately as reimbursed expense income, and should not be posted as a credit to the reimbursable client cost expense account.
- “Third-party” costs or liens occur in some practice areas, e.g., personal injury. Third parties advance costs or liens need to be satisfied at settlement, for example unpaid hospital bills. These liabilities are not associated with the firm and do not appear as part of the firm’s financial statements. However, it is the obligation of the attorney to ensure payment. In this latter situation, failure to properly track and reimburse third parties may be a breach of compliance regulations.
Figure 3 shows the allocation of a partial payment of $2,700.00 on an invoice total of $3,278.00. Note that direct costs are paid in full rather than apportioned. This is compliant with legal accounting regulations.
Figure 3. Illustration from Law Firm Accounting Demystified
Resources … Finally
Resources on how to handle legal accounting have been scarce. Googling “accounting for lawyers” or “bookkeeping for lawyers” or “legal accounting” brings up weak, sometimes irrelevant, results. The top hits are commonly software applications, followed by generic whitepapers. Wading through the links to find answers is frustrating and time-consuming.
Now there is a resource to help attorneys, staff, and accounting professionals get answers. A new website dealing specifically with law firm accounting was recently launched – Legal Accounting Guide. There are articles by experts, resources by state, and a new book available free as a PDF download, Law Firm Accounting Demystified, which provides a comprehensive reference into the many subtleties and nuances of legal accounting. For purposes of full disclosure, Rick Kabra, CEO of CosmoLex, and I co-authored the book.