I wouldn’t make for a great defense lawyer: I cry when arguing about the most insignificant things. But you can leave the law firm accounting to me.
Overview: How does accounting for law firms differ from other types of accounting?
Law firms juggle their clients’ money more than in most industries. Accountants in law spend much of their time tracking what money the firm earned and what needs to go to clients, the courts, or third parties.
Money comes into law firms from all directions. For example, a law firm might earn its revenue through settlements, where it never sees a dime directly from the client. Clients often pay retainer fees to commit their counsel’s time to their legal matters. Unique payment methods make accounting for law firms different from other types of accounting.
What special considerations do accountants for law firms need to pay attention to?
Shocker: Legal accounting has rules up the wazoo. Brush up on your accounting 101 skills before diving into what I’d consider accounting 201 material.
1. Client trust accounts (CTA)
Any money that your business holds onto for a client and hasn’t earned goes into a client trust account (CTA). You can open a CTA at banks that offer business bank accounts.
Say your client paid you $20,000 in advance, knowing the attorney fees will far exceed that amount. Since you have yet to earn the $20,000, you’re required to put it in a CTA. Many CTAs earn interest for the client’s benefit.
The American Bar Association (ABA) says law firms most often open CTAs:
- To hold legal fee prepayments
- To hold settlements, payable either to a client or third party
- To manage a client’s estate
Law firms can get in trouble when they withdraw unearned funds from CTAs. The money in a CTA isn’t immediately yours — you’re called a fiduciary, requiring you to exercise the highest standard of care with your client’s funds. You can only move CTA funds into your business operating account after your client approves an invoice.
Like every bank account, CTAs come with bank service charges. Some states prevent law firms from depositing their own funds into CTAs, so you’d pay them from your operating account. In states that allow it, you’d deposit just enough to cover the fees. You’re free to bill the client for the charges your firm paid.
Any funds that go into a CTA are a liability on your balance sheet because it’s money you’re holding but didn’t earn. We’ll get into the nitty-gritty bookkeeping later.
2. Interest on lawyers’ trust accounts (IOLTA)
Interest on lawyers’ trust accounts (IOLTAs) are a type of CTA. While other CTAs earn interest for clients, IOLTAs send the interest to state-sponsored programs that fund law school scholarships and law services for the poor.
It’s customary to use IOLTAs when you’re depositing nominal amounts that would earn little to no interest. The state pools the funds from individual IOLTAs to generate enough revenue to fund the public programs. You’ll want a traditional interest-bearing CTA for substantial deposits or funds you plan to hold long term.
Some states oblige law firms to use IOLTAs in certain situations, so check with your state bar association for rules for your firm.
You can’t use IOLTA funds to pay bank fees. If the bank doesn’t waive or cover IOLTA bank service charges with interest earnings, you must write a check from your business’s operating account. Again, you can bill the client to reimburse you for the expenses.
You can use the same IOLTA for multiple clients, but you must have a reliable method to track each client’s running balance.
3. Retainer fees
Most law firms accept retainer fees that secure lawyers’ availability for a client’s legal matters. Retainer fees are paid up front and usually recur monthly. How you account for retainers depends on the agreement.
True retainers are non-refundable and immediately count as revenue to the firm. You don’t have to put the funds in a CTA and slowly draw from it as your associates toil away. It’s all yours from the jump.
Refundable retainers — where the client may have a refund for hours prepaid but not worked during the month — are what accountants call unearned or deferred revenue. The retainer fee goes into a CTA, and you can draw from it as the client approves invoices for services rendered.
Retainer agreements can get complex, but I don’t need to tell you that. The differentiating factor for accounting is whether there are contingencies or refundability clauses in the retainer contract.
4. Partner compensation
The standard law firm business structure is a limited liability partnership (LLP). Owners, called partners, enjoy the benefits of pass-through taxation under a shield that protects their personal assets from business liabilities. Partners are paid differently from employees.
Lawyers use the term “partner” more liberally than accountants. Some firms promote lawyers to a partner title without making them a part owner in the business. From an accounting perspective, a partner with no equity in the firm is still an employee.
The distinction matters because equity partners can’t earn salaries like employees. They’re taxed based on their portion of the firm’s earnings and pay themselves through an owner’s draw. Some partners also earn guaranteed payments to ensure stable income even if the business operates at a loss.
In contrast, employees earn wages, and companies must withhold payroll taxes from their wages. Non-equity partners must be taxed as employees.
Accounting best practices for law firms
Follow these tips to ensure compliance with legal firm accounting.
1. Don’t commingle operating and CTA funds
You’re not allowed to have your client and business funds in the same account. In other industries, you’re allowed to keep clients’ prepayments in your operating account and use the money to fund client projects and pay the rent. Law firms don’t get that luxury.
It’s tempting to borrow money from a CTA, knowing that some of the money in there will soon be yours. Don’t do it: You can be disbarred, unable to practice law.
Accelerate invoicing to avoid a cash flow problem where you’re spending money on your client’s behalf without getting it back from them.
2. Train bookkeepers in law firm accounting
Make sure your bookkeeping staff knows law firm accounting procedures. Your bar license is at stake any time your firm improperly moves client funds, even if you didn’t do it.
3. Set up asset and liability accounts for your CTA
You need to create two accounts for each CTA. The asset is the bank account — just like your cash account — and the liability recognizes that the bank account balance doesn’t belong to your business. The asset and liability amounts should always match, making no impact on your financial statements.
Any time you deposit money into a CTA, record this entry in your accounting software:
View more information: https://www.fool.com/the-blueprint/law-firm-accounting/