Unless you specialize in tax law, you’re probably not an accounting expert, but understanding accounting basics can help lawyers ensure their legal practice complies with ethics rules and accounting regulations.

Unlike other business owners, lawyers need to be familiar with two types of accounting: business and legal. While there is overlap between the two, there are differences, especially when handling client funds.

Differences between business and legal accounting

Business accounting is what law firms have in common with other businesses and includes expenses of running the law practice such as overhead, payroll, office rent, assets, liabilities, and equity.

Legal accounting is specific to law firms. It encompasses matter cost and income accounting — client costs, reimbursements, and fee income — as well as fee advances and retainer accounting.

Properly tracking the posting and reimbursement of matter costs is essential to ensure the firm’s accounting records are compliant. Law firms typically have two types of matter costs:

• Hard (direct) costs cover matter expenses with advance payment to vendors by the firm, such as court reporters, filing fees, and expert witnesses. These can be billed directly to the client.
• Soft (indirect) costs cover items involved with the normal course of doing business, including copy and fax charges, data storage, and phone calls. Some firms absorb these costs; some may add a general overhead fee to client invoices, while others choose to itemize these expenses individually.

In accounting terms, any retainers received are liabilities — funds that haven’t yet been earned and still belong to someone else (the client).

Trust accounts are bank accounts set up specifically to hold client retainers.

General tips for accurate legal accounting

• Keep operating and trust accounts separate. Remember, money in a trust account still belongs to the client. Law firms can’t access this money until they’ve earned it. On the other hand, the operating account belongs to the law firm. Although money may be moved from the trust account into the operating account once work is completed and billed for, these two accounts are distinct and must be treated as such.
• Deposit funds in the correct account. Funds that can be deposited into a trust account are generally limited to settlement funds, distributed to one or more parties (commonly found in personal injury or real estate), and retainer fees for work to be done. Third-party funds, judgment funds, and advances for cost should also be placed in a trust account. Earned income belongs in an operating account, as do any funds unrelated to the client. The operating account is the account from which business expenses should be paid.
• Track individual client ledgers. All client money held in trust must be tracked. Failing to do so is an ethics violation. Each client or matter account needs its own ledger with individually tracked balances and transactions. Tracking individual client balances helps maintain awareness of when retainers are getting low and need to be replenished.
• Avoid over-drafting a client ledger. Over-drafting one client account often means funds are pulled automatically from another, resulting in a law firm accessing unearned client funds. Ensure safeguards are in place to prevent over-drafting.
• Don’t commingle funds. This is another ethics violation, and it occurs when individual funds aren’t separately maintained, specific to their individual matter, regardless of whether funds are being mixed with other clients’ funds or the law firm’s funds. There is one exception: when a law firm needs to cover service charges related to the account.
• Reconcile regularly. Doing so helps law firms catch errors. It’s also required for trust accounts. The required timeline for reconciliation varies by jurisdiction.

Consult with an Expert

Well-prepared and organized financial data not only helps with compliance but also offers critical insights into the operations of a law firm. Accountants can help law firms lay the foundation and establish best practices allowing firm leaders to focus on growing the firm.

Give our team a call if you need help ensuring you meet all of the regulatory requirements for your firm’s financial situation, including:

• Partner compensation disputes
• Associate and staff compensation levels
• Employee retention issues
• Control of expenses
• Lawyers’ trust accounts
• Improvement of collections
• Maximization of billable hours