Picture this: You have just found out your law firm’s trust accounts are about to be audited. What’s your first reaction?
Managing client funds is a significant responsibility, and unfortunately, we’ve all heard stories of lawyers who fall short of fulfilling their duty—unintentionally and in some case, intentionally. As a result, trust accounting, or IOLTA, has drawn the increased attention of regulators in recent years, so it is critical that your practice’s accounts are managed in accordance with state requirements.
Understanding the basics of trust accounting and specifically, three-way reconciliation, is key to staying compliant. First, it’s important to recognize the major components of legal accounting:
- General Accounting
- Matter Cost/Income Accounting
- Fee Advances/Retainer Accounting
When it comes to properly handling trust accounts (which falls under “Fee Advances/Retainer Accounting”), firms must be aware of the types of funds that can be kept in a trust and those that strictly cannot:
- Settlement funds (e.g., personal injury, real estate settlements)
- Unearned income (e.g., “fee and cost advances” or “retainer”)
- Judgment funds
- Third-party funds
- Personal funds
- Earned income
- Payroll (i.e., business expenses)
- Any funds for which you are not the fiduciary trustee
In many ways, trust accounting is fairly simple. It doesn’t take into consideration profit or loss, there’s no depreciation, amortization, or interest accumulation to keep track of, plus no need for tax accounting or account management for fees/bank fees.
That being said, trust accounting does require that funds are tracked for each matter, the books are reconciled monthly, and an audit trail is always maintained.
The following 7 reports are vital for proper trust account management, and if conducted regularly, will significantly improve a firm’s recordkeeping and compliance practices:
- Bank ledger
- Receipts journal
- Disbursements book
- Client ledger balance
- Individual client trust ledger
- Bank reconciliation
- Three-way reconciliation
These last two practices, bank reconciliation and three-way reconciliation, are particularly essential to trust accounting. It is often at the point of bank reconciliation that errors are detected, and it also allows the firm to:
- Ensure books are in sync with the bank’s actuals
- Locate possible bank and book mistakes
- Identify problematic transactions such as funds that haven’t been cleared for an extended period
- Produce reconciliation reports
Keep in mind, books must be closed until reconciliation is complete; you don’t want any accidental edits. Additionally, keep a hard copy of the reconciliation report (or make sure you can go back and print). Some accounting systems only allow you to print the last reconciliation report, so be aware.
But what is a three-way reconciliation exactly?
We’re glad you asked. Unique to trust accounts, a three-way reconciliation must be completed monthly for each trust account your firm handles. It ensures the sum of the individual
client ledgers totals the same as the bank balance and the book balance. Not only does running this report prove that an account is being managed properly, but it also verifies the individual client ledgers are correct.
That being said, there are some common struggles associated with generating a three-way reconciliation, so it’s important to keep the following in mind to produce accurate reports:
- You must stay on top of monthly reconciliations
- Records must be kept by client ledger
- Generic software does not account for ledgers or trust, nor produce compliance reports
- Most firms don’t realize what they “can’t do” until they are audited
Fortunately, recent technology makes the reconciliation process easier than ever, and a legal-specific solution like CosmoLex provides a fully integrated trust accounting workflow that simplifies the process of generating accurate reports, including three-way reconciliation. So, if and when that audit comes around, you’ll be able to face it with confidence and ease, knowing your trust accounts are already being handled properly.
To learn more about the most important trust accounting reports for law firms, be sure to view our webinar, The 7 Vital Reports for Trust Accounting.