Law firm accounting is a little more complex than regular business accounting. There are a few more components that are thrown into the mix, like trust funds, that adds a different dynamic to the accounting process for law firms.
If you own a small law firm, you need to understand the basics of accounting for law firms, why bookkeeping and accounting for law firms are so essential, and the best practices for law firm accounting.
Once you have a good grasp on all of these elements, the rest will fall into place.
What is the difference between bookkeeping and law firm accounting?
The terms “bookkeeping” and “accounting” for law firms are sometimes used interchangeably but they actually take the same financial data and do very different things with it.
Bookkeeping refers to the administrative task of recording financial transactions and balancing financial accounts. Bookkeepers basically keep track of the money coming in and going out of the firm. Bookkeepers provide the financial data that accountants need to perform their duties. Bookkeeping is the foundation for legal accounting.
Bookkeepers typically perform the following tasks:
- Record financial transactions
- Balance accounts
- Reconcile financial accounts
- Handle invoicing
- Manage payroll
Accountants take the information provided from the bookkeeper and work their magic. Accountants summarize, analyze, and interpret this financial data. With this information, they can advise law firm business owners on financial decisions, financial forecasting, help a firm stay compliant, and move the firm towards growth.
Accountants are known to perform the following tasks:
- Manage financial data using financial statements
- Analyze expenses
- File tax returns
- Handle trust accounting for clients
- Case cost accounting
- Analyze monthly and annual revenue and income
Why is bookkeeping and law firm accounting important?
Efficient bookkeeping and accounting practices are critical to a law firm’s growth and success. The following are three reasons why this process is so crucial:
1. Law firm bookkeeping and accounting keeps your company compliant
Every law firm must remain compliant with certain regulations. Law firms must follow certain standards when it comes to recordkeeping, holding funds in trust, and notifying clients of the receipt of property or funds. Violating legal accounting and compliance regulations can lead to financial penalties, the suspension of license, and even disbarment.
2. Law firm bookkeeping and accounting is a necessary process for business growth
Bookkeeping and accounting for law firms allow you to collect, record, and analyze financial data. Analyzing this information helps determine what areas of the law firm are working efficiently and what areas need some work.
That way you can concentrate on those areas needing work to make the firm as efficient as possible. The most efficient firm will minimize expenses and maximize profit, which is the only path that will lead to business growth.
If you didn’t have a system in place to track what money is coming in and going out of your firm, then you would never know where your law firm stood financially. Without this information, your business would never get off the ground, grow, or succeed.
3. Law firm bookkeeping and accounting prevent you from ruining your business’s reputation
If you don’t have an effective bookkeeping and accounting system in place, you risk missed payments, late payments, missed filings, late filings, or a mismanagement of funds. Accounting mistakes make law firms look unprofessional. Unprofessionalism can ruin a business’s reputation. A less-than-stellar reputation can lead to a loss of business and even run your law firm into the ground. Therefore, it’s imperative that you run your business based on a fool-proof financial process.
What are some best practices for law firm accounting?
Even though legal accounting is a little more complex, there are some things that you can do to make the accounting process for law firms go as smoothly as possible.
1. Establish separate bank accounts
It’s very important to establish separate bank accounts in a legal accounting system. Under no circumstances should you ever mix personal and business expenses.
There are at least three main bank accounts that you should open for your law firm. Before you can open a business bank account, your business will need to be registered with the state, have a business name that is registered and have an employer identification number (EIN).
a. Checking account
The checking account is a good place to manage business revenue.
b. Savings account
A business savings account is a good place to set aside and store money for unexpected emergencies, taxes, or money that you will need at a later date.
c. Interest on lawyers trust account (IOLta accounts)
Law firms hold client funds in a separate trust account called an IOLTA account. IOLTA accounts are lawyers’ trust accounts and have very specific rules regarding what you can and can’t do and they have stiff penalties for breaking these rules.
Here are some things to keep in mind when managing trust accounts:
- Never withdraw any fee from an IOLTA account before it is earned. Don’t ever borrow money from an IOLTA account.
- All trust and business accounts must always be separated. An IOLTA can never be used as an operating account or as a savings account.
- Trust deposits are never recorded as income. These are not your funds, but funds you owe your clients.
d. Three-way trust reconciliation
If you have any trust accounts in your firm, every 30-90 days you will need to carry out a three-way reconciliation. A three-way reconciliation involves the matching of three balances. These include the one on the trust account ledger, the total of all of the individual client’s ledgers, and the bank statement for the trust.
2. Choose your accounting method
Law firms have two options when it comes to keeping their books: cash accounting or accrual accounting. You need to choose this method carefully because it will affect your tax filing, cash flow, and how your bookkeeping is done.
a. Cash basis accounting
With cash accounting for law firms, revenue is recognized when cash is received and expenses are recognized when the expenses are paid. With cash accounting, accounts payable and accounts receivable are not recognized.
b. Accrual accounting
With accrual accounting, revenue and expenses are recognized when they are earned and incurred. Accounts payable and accounts receivable are recognized in accrual accounting.
Most law firms use the cash accounting method, but the method that is best for your law firm will depend on your accounting needs. It’s best to consult with an accounting professional to help you choose.
3. Establish a budget
If you don’t establish a plan, then it’s hard to attain goals. In order for your law firm to be successful, it’s essential to create a budget. A budget will act as your road map in keeping your firm on track while pursuing those goals.
Establishing your budget will include setting benchmarks for revenue, establishing an amount for expected expenses, setting aside an amount for unexpected expenses, and getting a feel for the kind of cash flow that will be needed.
4. Keep a close eye on trust accounting
More errors occur with trust accounting than any other area of accounting for law firms. In fact, trust accounts are a unique component of legal accounting. Law firms must follow certain legal industry regulations based on their jurisdiction.
One of these is to maintain detailed and comprehensive records for their client’s trust accounts. Lawyers are also required to have multiple bank accounts. One should be an operating bank account and there should be a separate account for Interest on Lawyer Trust Accounts (IOLTA). IOLTA accounts are used to hold client funds.
5. Review financial statements monthly to spot opportunities
By reviewing your firm’s finances on a monthly basis, you’ll get a good feel for your firm’s financial picture and you will be better equipped to spot opportunities to reduce expenses and overhead and spot opportunities for financial growth.
The following are some financial statements and reports that law firms should review on a monthly basis:
- Profit and loss statement
- Unbilled time report
- Accounts receivable
- Balance sheet
- Accounts payable
6. Hang on to supporting documents
It’s important to keep all supporting documents that back up the financial data that you have submitted on your tax returns such as income, deductions, and credits. You will need these documents if you are ever audited.
These documents include the following:
- Bank statements
- Credit card statements
- Canceled checks
- Proof of payments
- Previous tax returns
- Accounts receivable journal
You should hold on to these supporting documents for the specified time required by the IRS. You can even keep digital copies of receipts produced by apps and online services such as Shoeboxed where the receipts are scanned and saved in digital files.
7. Keep track of tax deductions
A lot of business expenses incurred can be deducted on your tax return. These are expenses that are incurred while doing business.
The following are some deductions that law firms commonly take:
- Business travel
- Home office expenses
- Professional publications subscriptions
- Training, seminars, conferences
- Business-related car expenses
- Business transportation costs
You need to make sure you hold on to all receipts for any deductions that you take as supporting evidence that the transaction occurred.
8. Use legal accounting software
Accounting software simplifies the financial management process for law firms. It is a great tool for tracking all of the firm’s financial transactions. Industry specific accounting software is always the way to go and attorney-specific software actually does exist.
With legal accounting software, you can manage your accounting needs from anywhere at anytime. create digital invoices, have instant access to your firm’s cash flow in real time, and reconcile accounts instantly. It will save you a lot of time and money, not to mention, frustration.
Frequently asked questions
Bookkeeping is an administrative task that involves recording all of the law firm’s business transactions and reconciling and balancing the firm’s financial accounts.
Law firms can choose one of two accounting methods. They can choose either cash accounting for law firms or accrual accounting for law firms.
FreshBooks is considered one of the best legal software for law firm accounting. It’s a cloud-based accounting software that works well for those in need of small law firm accounting software.
One of the main things to look for in a bookkeeper is to find one who specializes in accounting for law firms.
Even though bookkeeping and accounting for law firms is more complex, it is a very doable process with a little knowledge and experience. The two main goals when it comes to accounting for law firms is to ensure that the law firm remains compliant with all ethics rules and that the law firm reaches its full potential for growth. Legal accounting is going to require a professional accountant at one point or another, so don’t hesitate to call one when needed. It will end up saving you a lot of time and money in the end. You can take the additional step and learn about the accounting cycle to stay compliant and transparent with your financial health.
Caryl Ramsey has years of experience assisting in different aspects of bookkeeping, taxes, and customer service. She uses a variety of accounting software for setting up client information, reconciling accounts, coding expenses, running financial reports, and preparing tax returns. She is also experienced in setting up corporations with the State Corporation Commission and the IRS.
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