Like any valuable asset entrusted to your care, handling client funds demands a great deal of responsibility and attention to detail. Before establishing a system to adequately manage such funds, however, your firm must first fully understand legal accounting, an element that many practices often neglect. While some attorneys may consider accounting outside their realm of expertise, the reality is, you must have a working knowledge of its components. So, today, we’re offering a crash course in law firm accounting, followed by a list of do’s and don’ts for handling client funds.
Law Firm Accounting 101: What You Need to Know
Before any law practice opens their doors and begins accepting clients (and their money) it’s important to understand these three basic differences in legal accounting:
- Business accounting (also known as “back office” accounting). This includes the facility, payroll, paper, computers, and so on. Every business, regardless of industry, deals with this sort of accounting and uses it to book revenue and expenses in order to track profits and losses. While assets, liabilities, and equity are included in the balance sheet, business accounting does not deal with fiscal matter management – that is an area unique to law practices.
- Matter cost/income accounting: use this to properly post client costs, cost reimbursements, and fee income to the general ledger.
- Fee advances/retainers accounting: manages client funds being held on account to pay legal fees and expenses. It may also include escrow funds such as personal injury settlements and disbursements of those funds.
When it comes to legal accounting, it’s important to recognize that not all funds are the same. Depending on your jurisdiction and firm’s procedures, client retainers are not always exclusively held in trust accounts. You may also encounter operating retainers and trust retainers. Operating retainers include advances received into the operating account. This is revenue not yet earned and is a liability to your firm. On the other hand, trust retainers include advances/funds received into the trust account. Like operating retainers, this is revenue not yet earned, and therefore, is also a liability to your firm.
At this point, you may be asking yourself, “What is the best way to handle client retainers? Should my firm be putting client retainers in an operating account or a trust account?” Ultimately, there is no right or wrong answer. While law firms may be permitted to keep client retainers in operating or trust accounts (depending on your jurisdiction), it is important that these funds are properly accounted for and applied to the client matter with which it is associated.
Now that you’re up to speed on the nuts and bolts of law firm accounting, let’s talk about a few dos and don’ts of handling client funds.
The Basic Do’s & Don’ts
DO: UNDERSTAND WHICH FUNDS GO WHERE
As mentioned before, the type of account in which a retainer is deposited depends on your jurisdiction and your firm’s procedures. There are several other factors to consider, including compliance mandates as well as the type of law you practice; certain funds, such as settlements or escrow, must go through trust.
While retainers in an operating account may be included with a variety of other transactions, trust accounts have very specific requirements as to what can and cannot be deposited. To review, the different types of funds in trust include:
- Settlement Funds, which are most common in personal injury cases or real estate settlements. Typically, there is one deposit, which must be disbursed to one or more parties.
- Unearned Income: your state may allow advances or retainers to be held in operating accounts as well, so be sure to follow local guidelines properly. In most cases, this would depend on the nature of the engagement (e.g. retainer agreement, etc.).
Keep in mind: it is always possible that you may need to return funds to the client (because you’re no longer representing the client or the case closes prematurely, for example). Because of this, a good rule of thumb may be to always use a trust account.
- You may also have Advances for Cost and Judgement Funds (typically associated with contingency cases), and third party funds.
These funds are strictly not allowed in trust accounts:
- Personal Funds: anything not client related does not belong in trust. In some cases, nominal personal funds are allowed to cover “service or bank charges.”
- Earned Income, which should be withdrawn and deposited into your business account.
- Payroll, which is a business expense.
- In any situation where you are not the fiduciary trustee, you should not be managing funds in a trust account.
DO: HAVE A DISTINCT SEPARATION BETWEEN OPERATING & TRUST RETAINERS
You may be handling client funds in an operating account, trust account, or both; regardless, there must be a distinction the two. Be careful, as most legal billing systems do not include accounting functionality and cannot adequately differentiate accounts, particularly when dealing with retainer deposits. A legal-specific solution that combines both legal billing and accounting together in one system ensures that your firm’s handling of client retainers – however you choose to do it – remains clean and compliant.
DO: TRACK INDIVIDUAL LEDGERS
Irrespective of the type of account your firm uses to manage client retainers, one fact holds true: every penny must be accounted for and attached to the appropriate client and matter with which it is associated. Failing to properly account for retainer deposits can result in bookkeeping nightmares and ethics violations. As a result, each matter should have its own individual ledger containing its balance and transactions. Also, it is generally good practice to have a system in place that allows you to easily communicate with your clients and enable them to always be aware of the funds that are currently available from their retainer.
DON’T: COMMINGLE FUNDS
This goes hand-in-hand with tracking ledgers individually: ensure you are always aware of a matter’s balance, and that transactions only affect the respective matter’s balance. Funds from anywhere other than the matter’s client should never be used to pay for matter expenses. Remember, commingling of funds can take on a variety of forms:
- Personal funds in the trust account (aka “buffer”)
- Not tracking funds by individual matters
- Operating and trust retainers not tracked separately
- Overdrafting on an individual ledger
DON’T: OVERDRAFT ON A LEDGER
Whenever client funds are concerned, it is essential to understand that disbursements or invoice payments should not affect any balance other than the related matter. Overdrafts typically occur unintentionally because general accounting solutions are not programmed to handle legal trust accounting. Legal-specific trust accounting software often includes safeguards against such occurrences and prevents mistakes before they are made.
DO: MAINTAIN EVERGREEN RETAINERS
Keep in mind, even if your practice is entirely retainer-based, retainers deplete. Have a process in place that tracks the minimum balance allowed. Once that number is reached, immediately seek replenishment so that you are never left without a balance. There are many tools that can assist with this, including systems that can send automatic email reminders.
DON’T: ASSUME ALL MERCHANT PROVIDERS KNOW HOW TO HANDLE RETAINERS
As you compare credit card merchant providers, remember that all programs and integrations differ, so be sure to ask the important questionsprior to doing business:
- Do they support operating and trust accounts?
- Credit cards are not just for invoices anymore. You may want to accept trust retainers as well.
- How are processing fees handles?
- You need to be aware of how these fees will be charged to you. Typically, a monthly deduction is made from your account. However, some merchant providers do not take compliance into account when handling trust accounts. They may deduct those fees from the trust account, which will commingle funds and make reconciliation a hassle. If your firm plans to process trust transactions, choose a merchant that knows how to work with trust accounts and only deducts fees from the connected operating account.
- Does the service integrate with your billing program?
- While credit card payments are an added convenience to your clients, you want to streamline the process on the backend as much as possible.
DO: RECONCILE REGULARLY
It is important to regularly reconcile your bank accounts to catch any mistakes that may have occurred. These can be keying errors or even bank mistakes. Having one program to manage your retainers (for billing purposes) and your reconciliation (for accounting purposes) is optimal. Otherwise, you may end up with two sets of records that don’t match.
In addition to monthly reconciliation statements, look into utilizing bank feeds for daily reconciliation. This way, you can monitor in real-time what has cleared and if any errors have occurred.
DO: MAINTAIN PROPER REPORTS
Reconciliation is only as good as the reporting. You want a detailed report for all cleared and uncleared items as well as a three-way reconciliation report. This not only checks your bank and book balance, but it also adds up trust ledger balances to ensure the three match.
To return to the ideas discussed at the beginning of this post, in order to best handle client funds, firms must begin to bridge the gap between billing and accounting. By combining your practice management (i.e. billing, calendaring, documents, tasks, etc.) with your law firm accounting, you’ll end up with a complete law firm management solution that provides the peace of mind of knowing your firm is remaining compliant, without having to worry about each transaction. If you’re interested in learning more about the Do’s and Don’ts of Handling Client Funds, watch this recent CosmoLex Webinar Series presentation here.