Regardless of the size of your law firm, it’s important to know accounting and bookkeeping basics to ensure that your business is compliant with ethics rules. In this article, we present law firm accounting tips and best practices for accurate and efficient accounting, along with the challenges unique to law firms.
1. Stay on Top of Trust Accounting
Trust accounting is a required aspect of accounting for law firms. It’s the practice of keeping client funds given in trust, including unearned fees paid as a retainer, court fees, settlement funds, or advanced costs, in a separate account from law firm operating funds.
Trust accounts are among the most common areas of accounting for law firms to make errors because they have very specific rules about what you can and can’t do with them. The penalties for breaking these rules can be severe, including disbarment.
It’s important to adhere to best practices, or you may accidentally commingle funds and put your firm at risk. As rules vary by state, consult your state bar association and a professional accountant to ensure that you’re following the proper protocol.
2. Perform Three-Way Reconciliations
Every state bar requires you to perform a three-way reconciliation every 30 to 90 days between the trust bank account, trust ledger, and individual client ledgers. A three-way trust reconciliation involves the following:
- Reconciling the Trust Bank Account to the Trust Ledger
The trust ledger is similar to a checkbook register and should include every trust transaction for every client. This trust ledger must be reconciled to the bank statement for the trust funds account. There may be some trust transactions in the ledger at the end of the period, which will appear as outstanding items on your reconciliation. This is fine but look closely at the outstanding items to ensure they aren’t an incorrect ledger entry.
- Reconciling the Trust Ledger to the Individual Client Ledgers
While the trust ledger includes all trust transactions across all clients, the individual client ledgers separate these transactions by client. The sum of all the client ledgers must equal the balance in the trust ledger. There should be no reconciling or outstanding items because entries in the trust ledger and client ledger should happen simultaneously.
If you want to ensure that your trust accounting is correct, we recommend looking into our best law firm accounting software.
3. Set & Stick to a Budget
It’s important to set a budget for your law firm to create expectations for cash flow and expenses and set revenue benchmarks. Budgeting makes it easier to set aside funds for larger expenses, such as annual bar association dues, legal research services, and information technology (IT) upgrades.
While there are many ways to establish a budget, you first need a strategy. Start by making a list of your mandatory expenses, such as license fees, rent, and utilities. Then, set realistic personal and business goals, such as how much time you want to take off for vacation and whether you want to hire employees or contractors. After projecting your revenue, you can take a realistic look at what you need to do to achieve your goals.
4. Ensure Easy Expense Reimbursements
To ensure easy expense reimbursements, it’s a good idea to require that all employees and partners use a company credit card. Doing this makes it easier to track expenses for each client and partner and creates a more direct paper trail. Reimbursable costs are typically known as advanced client costs.
There are also cases where expenses that an employee or partner needs reimbursed are paid from personal funds. In those situations, we recommend using an expense tracking app like Zoho Expense, which allows you to approve employee expenses.
5. Maintain Compliance for Client Funds
Every law firm has a responsibility to stay compliant with ethics regulations and, while ethics rules vary in each jurisdiction, there are some basic commonalities when it comes to accounting for law firms. Whether intentional or through neglect, violating compliance regulations, such as mishandling client funds, can lead to serious repercussions like significant financial penalties, suspension of your license, or disbarment.
The American Bar Association (ABA) outlines many rules that you’ll want to be aware of. One in particular is Rule 1.15: Safekeeping Property, which outlines responsibilities regarding trust accounts, recordkeeping, and keeping clients in the loop regarding their funds and property.
6. Streamline Time & Mileage Tracking
Billable hours can be the key to a law firm’s success, and it’s essential to have a time tracking system that’s both easy to use and efficient. Once you have an effective system in place, be sure to put it to work every time you complete a task for a client. Don’t forget to include the details, like who you spoke with or what type of meeting you conducted.
Employing a mileage tracker app can ensure that you and your employees are reimbursed for all of your business mileage. Many platforms can run in the background on your phone and start and stop trips automatically based on the movement of your phone. You can classify trips as business or personal later on and add client information. They can also be used to calculate tax deductions, control mileage costs, and plan for future expenses.
If you’re just getting started, then consider using one of the best free time tracking software until you get your legal accounting system set up.
7. Project Future Cash Flow
It’s important to monitor your accounts receivable (A/R) aging report to stay on top of any outstanding invoices and follow up if necessary. Your outstanding A/R will also provide information on cash you should receive in the near future. It’s also important for attorneys to forecast when settlements will be finalized and when they expect to receive their share of the proceeds.
8. Avoid the Accrual Method of Accounting
New firms need to select their preferred accounting method, which must be done before the firm files its first tax return. You can go with an accrual or cash method, but law firms are almost always personal service corporations (PSCs) and are, therefore, allowed to use the cash method of accounting, regardless of size.
The cash method better matches taxable income with cash received and makes it easier to pay the tax liability. You can elect the cash method of accounting by using it on the first return. If you have already filed a tax return using the accrual method, you’ll need to file a request with the IRS to change to the cash method.
Read our guide on the accrual vs cash accounting method to learn when to use each.
9. Simplify Financial Tasks With Accounting Software
While it may be tempting to save costs by taking care of accounting yourself, accounting software will help you save time on administrative tasks and give you insight into your firm’s financial well-being. The best law firm accounting software will even help you manage clients’ trust accounts, monitor expenses and time spent on cases, and maintain records so that you can bill clients accurately.
You may also hire a bookkeeper who specializes in working with law firms if you’re looking for extra help in this department.
10. Review Reports Regularly
There are a few reports that are crucial for law firms to review regularly, which include an unbilled time report, a profit and loss (P&L) statement and balance sheet, an accounts receivable (A/R) report, and work in progress (WIP) or pipeline reports.
By analyzing the data from these reports, you can focus on monthly revenue goals, or the amount of money you want to make each month. This number can be an average amount that takes into account that some months may be higher than others, depending on your area of practice and other market factors.
You can also set key performance indicators (KPIs) to help you accurately monitor your firm’s financial performance. For example, you can view the revenue billed and collected per month, the firm’s net income as a percentage of revenue, and the realization rate, or amount billed as a proportion of the number of billable hours worked.
Why Law Firm Accounting Is Unique
Because law firms receive retainers and advanced fee deposits from clients and must hold these fees in trust until earned, law firm accounting is more complex than regular business accounting. Here are a few requirements that set law firm accounting apart from other types of businesses:
- Trust accounting: This is where you store client funds, such as retainers and settlement fees, and they must be kept separate from your operating bank account. You’re responsible for recording the receipt and disbursement of these funds and posting the transactions to the client’s ledger account.
- Three-way reconciliation: You’re required to reconcile your bank and trust accounts along with the client trust ledger to ensure that all accounts are accurate. As a law firm, you’re required to do this every 30 to 90 days, depending on where you live.
- Compliance requirements: There are rules and regulations that you must follow to keep your law firm compliant. They change with every jurisdiction, so it’s a good idea to become familiar with what’s expected of you. Many of these requirements have to do with trust accounting.
Frequently Asked Questions (FAQs)
What is trust accounting used for?
Client funds, such as settlement fees and retainers, are stored in a trust account because they must be kept separate from your operating bank account. There are strict rules that apply to trust accounting, including the requirement to post all transactions in and out of the trust account to the client’s ledger account.
What is a three-way reconciliation?
A three-way reconciliation involves reconciling the trust bank account to the trust ledger and reconciling the trust ledger to the individual client ledgers. Every state bar association requires that a law firm reconcile their trust bank statement to their clients’ individual balances either monthly or quarterly.
Why should law firms avoid the accrual method of accounting?
Law firms should avoid the accrual method of accounting because cash accounting is simpler and less expensive to administer. If law firms used a pure cash accounting system, their financial statements would be relatively straightforward and the tax liability would be easier to determine.
Bottom Line
A basic understanding of law firm accounting best practices is crucial to ensure the proper management of your firm’s finances. Decisions about billing processes, the acceptance of payments, and trust accounting form the foundation for a firm’s financial success. Therefore, it’s critical to ensure that you’re following these law firm accounting tips to save time, boost profitability, and prevent potentially serious compliance issues.
