When handling a law firm’s accounting, you will encounter two classifications of costs. It is imperative that a law firm is able to differentiate between Direct and Indirect costs.
A “Direct Cost” (aka Hard Cost) can be identified as any disbursement a firm pays as a “direct” expense to a vendor on behalf of their client. These expenses can include filing fees, costs paid to expert witnesses, the cost of court reporters, and various other direct expenses paid to vendors for a firm’s client.
An “Indirect Cost” (aka Soft Cost) is identified as an “in-house” expense associated with a client matter. These costs can include postage, long distance phone calls, facsimiles, and even photocopies. Essentially these indirect costs are associated with the general business activity of a law firm that can be tied back to a client but isn’t paid directly on behalf of the client.
Why Separate Direct & Indirect Costs
It is important that a law firm is able to separate direct and indirect costs based on how they affect both the expense and income portions of legal accounting.
Direct & Indirect Costs In Relation To The Expense Portion of Legal Accounting
In the area of expense accounting, an expense such as photocopies has already been applied to a law firm’s profit and loss as an office expense. While it is legitimate to bill the client for part of this cost, it can not be booked as a new expense on profit and loss statement as it has already been expensed.
A direct cost, on the other hand, is a new expense and will have an effect on either the firm’s profit and loss or the balance sheet. direct costs, like filing fees, can be posted as either “Advanced Client Cost (Asset)” or “Reimbursable Client Costs (Expense)”, a decision which only you and your accountant can make. In instances where a direct cost is posted as an “Advanced Client Cost (Asset),” the law firm’s balance sheet is directly affected. And, when a direct cost is posted as “Reimbursable Client Cost”, the cost associated with the filing fees can be seen in the firm’s Profit and Loss.
Direct & Indirect Costs In Relation To The Income Portion of Legal Accounting
Indirect costs, upon reimbursement, are posted as “In-house Reimbursed Client Costs (Income)” and they affect the firm’s profit and loss. This cost will increase the income and effectively offsets the office expense associated with maintaining the copier in our example.
Direct costs are handled differently when it comes to a law firm’s income. In instances where costs associated with filing fees, these costs are expensed as a “Reimbursable Client Cost”. The direct cost reimbursement should post as “Reimbursed Client Costs (Direct) (Income)” in the firm’s Profit and Loss and will effectively offset the “Reimbursable Client Cost (expense)” booking. In instances where the direct cost is applied as an “Advanced Client Cost (Asset)”, upon reimbursement, the amount on this account on the client’s balance sheet will be reduced.
Tracking direct and indirect costs accurately could give the best law firm a popsicle headache. For that reason, it is best that you consult a legal accounting expert on these matters, but your firm can certainly alleviate a great deal of stress associated with the accurate tracking of direct and indirect costs by employing a legal-specific accounting program that accurately accounts for direct and indirect costs like CosmoLex.
The Cost Of Not Tracking Direct and Indirect Costs Separately
Whether a firm is posting direct costs as “Reimbursable Client Costs” affecting the Profit and Loss of the firm, or as “Advanced Client Costs” reducing the amount shown on a firm’s balance sheet, doing this inaccurately can have severe implications.
Inaccurately tracking direct costs can increase or reduce the net income of a firm in a given tax year. Not only could this create an increased tax liability for a law firm, it could also result in a legal accounting audit that could further result in compliance issues for the firm.