Accounts Payable: What Law Firms Need to Know

CosmoLex Team

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In the legal industry, a firm’s accounts payable is more than just the bills your office owes.  Part of being an attorney is acting as the fiduciary for clients. For an attorney, this means that they may have responsibility for certain client debts. If anything is to go wrong, or these financials are not properly managed, it is the firm that will come under fire.

For lawyers, dealing with their clients’ financials is a necessary part of the business, but unfortunately, it can be an extremely dangerous one too. More so than in any other industry, the legal world has rules and regulations in place concerning accounting. Failure to comply with these rules and regulations often result in penalties and disciplinary actions against law firms. Therefore, all legal professionals need to have a solid understanding of accounts payable and the very important role it plays in their business.

What Is Accounts Payable?

Accounts Payable (AP) is defined as money owed by a company to its creditors. In layman’s terms, AP is what a business owes but isn’t ready to currently pay.

To compare it to personal finances, AP is essentially the same as someone receiving their monthly credit card bill, but waiting until the last minute before the due date to pay the bill. That bill is much more likely to be paid on time, before the due date, if the person being billed receives a reminder or notification that it is due. Without a system in place to provide that reminder, the bill could go unpaid, rack up late fees, and destroy an individual’s credit.

Understanding Accounts Payable and its Relationship to A Firm’s Accounting

It’s no secret that tightly managed accounting for law firms is incredibly important. The way a firm manages its accounting has a major impact on its accounts payable.

The first thing a law firm or attorney needs to understand is whether their accounting is cash-based or accrual-based. The method used for tax reporting may be different than what is used for managing the firm. Firms may use different methods to benefit tax-wise while having more accurate information for running the firm. Additionally, the management of the firm’s own expenses will often be handled differently than the handling of the expenses of clients. (This is discussed in more detail below.) 

In the United States, most small professional services firms use cash basis accounting for taxes. It is only in instances where a firm has an inventory that they need to use accrual basis accounting for taxes. While this is true in the United States, firms just north of the border in Canada rely on accrual basis accounting.

Cash basis accounting requires firms to receive payment in cold, hard cash before anything is reflected in their financial statements. Likewise, expenses aren’t reflected in financial statements until they have been paid.

Accrual basis accounting, for firms in Canada and those that possess inventory in the US, is the opposite of cash basis accounting. Expenses are incurred once the bill is received, and income is earned and recognized on financial statements as soon as it is invoiced.

Depending on which type of accounting a firm is using the impact on the business’s financials will be different. Here are some common scenarios and how the type of accounting being practiced will affect the firm.

Sending an invoice to a client

Once services have been rendered, it is now time to invoice the client that the services were performed for. For firms using cash basis accounting, there is absolutely no financial impact. Cash basis firms require that an invoice be paid before it makes its way onto its financial statements.

For a firm using accrual basis accounting, accounts receivable and income are both increased once the invoice has been sent to the client. These firms do not need to wait for the invoice to be paid to include it on their financial statement.

Receiving payment from a client

Whether a firm uses cash basis accounting or accrual basis accounting, receiving payment from a client will impact their finances. While the payment will affect a firm regardless of the type of accounting they practice, the impact will be felt differently.

For those firms practicing cash basis accounting, both their cash and income will increase. In instances where firms use accrual basis accounting, the firm’s accounts receivable will decrease, while their cash will increase.

Receiving a bill from a vendor

For firms who practice cash basis accounting, receiving a bill from a vendor will have no impact on their finances. It isn’t until that bill has been paid the firm’s finances will be impacted.

Canadian firms and those in the US who have inventory and are using accrual basis accounting will see their accounts payable increase as well as an expense increase.

Paying a bill from a vendor

Paying a bill is something that will affect a firm’s finances whether they use a cash basis or accrual basis accounting. For cash basis firms, paying a bill means that their cash will decrease and their expense will increase.

Accrual basis accounting firms will see their accounts payable and cash decrease when paying a bill.

The Advantages of Accrual Basis Accounting & Managing Accounts Payable

For firms practicing accrual basis accounting, there are advantages to having a well-managed accounts payable system. Because accounts payable is the money a firm owes, it is important to know that cash will be available when bills become due.

Firms that can stay on top of both their accounts payable and accounts receivable can start to make decisions related to their cash flow. This may mean holding back payment on bills until the due date to manage cash flow or even paying bills early to receive a discount. Without a well-managed accounts payable system, it becomes difficult to make these decisions.

 Tax Accounting Versus Business Accounting for Law Firms

It’s likely that a law firm will need to look at their finances on a cash basis and an accrual basis. This is due to the fact that the way a firm manages its accounting for the health of their business versus how they manage their accounting for tax purposes can be different.

Many firms prefer to manage their accounting on an accrual business because it provides greater insight into the firm’s cash flow, or AR and AP. This also makes it easier for the firm to match income and expenses.

The problem with accrual basis accounting is when looking at it for tax purposes, there is potential that a firm would be taxed on money that they haven’t yet received from their clients. For tax purposes- cash basis accounting is a more effective way to look at a firm’s finances, ensuring that the business is not taxed on income that they haven’t realized yet.

For law firms who practice accrual basis accounting to better manage their cash flow, it is important to have their accountant adjust their business reporting to tax reporting or cash basis accounting when it comes time to pay taxes. Failure to do so can result in the firm paying unnecessary taxes, compliance issues, and create a source of leakage for the firm.

It’s Not Just Accounts Payable. It’s Accounts Payable for Law Firms, and It’s Different

Like most things related to the legal industry, accounts payable exists elsewhere, but inside the legal industry, it has its own set of unique requirements. For law firms, this means that there are three different types of accounts payable related to three different types of bills.

The truth is, not all bills are created equal and they must be treated differently. The 3 different types of AP can be broken out as follows:

Type 1: This first type of AP is used to manage normal office bills and the firm’s cash flow.

Type 2: The second type of AP is related to bills from vendors that will ultimately be billed to the end client.

Type 3: The third and final type of AP addresses 3rd Party Lien Claims.

Accounts Payable Type 1: Office Bills & Cash Flow

This type of accounts payable is effective in ensuring a firm maintains positive cash flow. Understanding what bills are due, and when, allows a firm to understand how much cash they will have on hand after their operating expenses have been taken care of.  

In addition, accurate tracking may allow you to take advantage of discounts or avoid interest payments. Vendors usually have specific terms on when payments are due. Sometimes there is a discount for paying early. This might be expressed as 2/10 net 30, meaning you can take a 2% discount if you pay the bill within 10 days of the date of invoice, otherwise payment in full is due 30 days from the date of invoice. By paying within 10 days, you can save money. Vendors may also charge interest if you don’t pay within the time specified. This means you are actually paying more for what you purchase. If you purchase a lot from a specific vendor you may be able to negotiate better terms as they will want to maintain your business. 

 Accounts Payable Type 2: Bills from Vendors to Be Billed to The End-Client

While the first type of accounts payable was simple, addressing back-office accounting. The second type of AP for law firms can be a bit more complex. For this type of AP, firms are dealing with the debt and finances of their clients, and the accounting will be heavily scrutinized. Failure to comply with legal-specific rules and regulations can result in ethics violations and harsh penalties.

 This type of AP calls for the firm to manage the vendor bills that will ultimately be billed to the end client. Here are some of the essential features and abilities a law firm should have in place to successfully manage this type of AP. 

  1. Ability to link bills to client cases– Most firms work with several clients. In some instances, firms are working on multiple cases with a single client. It is imperative that the firm can link bills from vendors to the specific case it is associated with.
  2. Ability to hold bills– In a perfect world every bill would be paid as it’s received, but we all know we don’t operate in a perfect world. In instances where a vendor has billed a firm, but the firm has yet to be paid by the client who the vendor’s services were being rendered for, it is important that these bills can be held. Holding these bills until the client has paid the firm maintains a healthy cash flow. This feature can be further enhanced by a system that creates automatic notifications to ensure that a held bill is still paid before it is due.
  3. Differentiation between client and firm bills– It is important that firms can differentiate between bills meant for their clients and bills meant for the firm. Often clients use retainers and trusts to pay for legal services. This means the firm may be in possession of funds that they haven’t earned. It is strictly prohibited that the firm use client funds for anything other than bills related to the client’s legal matter. Differentiating between bills to the client and bills to the firm ensure that only the appropriate funds are used to pay the firm’s bills.
  4. Appropriate allocation– It is commonplace for law firms to receive a single bill with charges for multiple clients. For example, a FedEx bill may arrive with charges associated with multiple clients. While the vendor is paid with a single check, the firm needs to allocate the charges to multiple cases in their own AP system.

Accounts Payable Type 3: 3rd Party Lien Claims

In personal injury cases, worker’s compensation cases, family law, and bankruptcy cases, 3rd party lien claims inside of settlements are more common than many realize.

A lienholder is an individual or organization to which the client legally owes part of the settlement.  Lienholders may include, but are not limited to:

  • Healthcare Providers
  • Medicaid or Medicare
  • The Veterans Administration
  • Worker’s Compensation Insurers
  • Health Insurance Companies
  • Auto Insurance Companies

Bills or lien claims from these entities should be itemized and include the full amount the client is in debt to the lienholder, and the eventual disbursement that is paid to the lienholder upon settlement.

Lienholders and lien claims can be accumulated as a case progresses, for this reason, it is important that the law firm maintains a “total view” throughout the entire case. This view should include the firm’s costs and any other matter costs the settlement will be obligated to fulfill. Doing this will simplify the process of creating a well-organized settlement or disbursement statement, ensuring both the firm and the client understand all obligations upon settlement.

In some instances, 3rd party lien claims may be negotiated down to a lesser value. When this occurs, firms should show both the original amount of the claim and the negotiated amount on the statement. This will create a clearer picture for the client.

Addressing the Challenges Associated with Accounts Payable

While accounts payable is prevalent across a wide range of businesses, attorneys need to look at it through a different lens and be aware of the legal-specific rules, regulations, and requirements.

This is a common theme for lawyers across many different aspects of managing their business. There are legal-specific concerns related to top billing, accounting, and practice management. These concerns are all interrelated and have a profound impact on all other areas of business.

So how does a law firm effectively navigate these challenges? The first thing that needs to be done is that the attorney must make sure they are well versed in the issues that are specific to the legal industry and find a solution that is specific to law firms.

Knowing that the different areas and aspects of a legal business are interconnected, it is beneficial to find a solution that can bring them all together. The most effective practice management solutions are ones that not only offer billing, accounting, and business management tools but ones that can integrate all of these aspects if your law practice into a single, seamless application — allowing you to focus less on the technology your practice is using, and more on practicing law for your clients.