As the owner of a law firm, it’s your responsibility to keep up with monthly reconciliation and financial recordkeeping. Even if you have an accountant, you need to review your firm’s numbers so that you have first-hand knowledge of how the firm is doing.
But since you have a degree in law, not accounting, there are a few things that may seem counterintuitive, such as client trust accounts showing up as liabilities on the balance sheet.
Below, we’ll cover accounting basics for trust accounts, including why some things show up as equity and others as liability.
Understanding trust accounts
Before we break down liability and equity on your balance sheet—and when and why liability becomes equity—we need to review trust accounts.
Client trust accounts contain money you’re holding “in trust” for a client. This may be money from a retainer fee, a settlement payout, or money you’re holding while acting as a fiduciary on behalf of your client or their estate.
Whatever the reason, the money in the account legally belongs to the client—even though you’re the one overseeing the account. This means you can’t access it. But since you’re responsible for it, you must keep highly detailed records of all money going into and out of every client trust account. These records serve as evidence that you aren’t dipping into the client trust account for any reason.
In the event of a random audit, law firms need to be able to hand over trust account records and financial paperwork and account for every cent.
Law firms must also run monthly reconciliation and three-way reconciliation. Generally considered a bit of a tedious chore, three-way reconciliation is nonetheless an essential tool for catching errors while they’re still fixable.
If you don’t want to do the reconciliation yourself each month, use legal trust accounting software to do it for you.
So, client trust accounts hold client-owned money. However, once money in a client trust account has been earned, it effectively becomes the lawyer’s money. At this time, the law firm should move the earned money over to the firm’s operating account.
For example, if the money in the trust account is being held as a retainer fee, it is unearned until you perform services for the client. Once you’ve performed work for the client, you can send them an invoice with a clear description of what they’re being billed for and then withdraw money from the trust account to deposit into your firm’s operating account.
Why trust accounts show up as a liability
When you are reviewing your balance sheets each month, the money in your client trust accounts will show up as a liability.
The balance of your bank account will show as an asset on the left side of your balance sheet. Assets are made up of equity and liability, which are recorded on the right side of the balance sheet. Your bank account balance (assets) will equal the amount of equity and liability combined.
Thus, when a client retainer fee is deposited, the bank account balance will go up. However, in order for the left and right sides of your balance sheet to stay balanced, the numbers on the equity and liability side of the page will need to adjust, too.
In accounting, liability is defined by the money that a business owes a non-owner. While you hopefully will not “owe” a client money because you are going to perform legal work and earn the money, a trust account balance showing up as a liability is a reflection of the fact that it isn’t the law firm’s money. It legally still belongs to a non-owner, in this case, the client.
Equity, on the other hand, is defined as the owner’s share of the assets. Specifically, equity is the owner’s share of the assets after all liabilities have been deducted. In other words, equity is the money that you have earned by performing services for the client.
Because this money now belongs to you, not the client, it should be in the law firm’s operating account. Since client trust accounts don’t hold any money that belongs to you, they will always show up as liabilities, not equity, on the balance sheet.
A lot of trust is placed in any fiduciary, including a lawyer. After all, clients are handing over their money and trusting you to take care of it.
With this trust comes responsibility and ethical obligations. The American Bar Association’s Model Rule 1.15 addresses which funds may be placed into or withdrawn from a trust account. Your state bar association will also have regulations in place.
It’s your responsibility to know and follow your jurisdiction’s trust account guidelines. They will vary by location, but all will require that you keep the client’s money in the client trust account and your earned money in the law firm’s operating account.
Staying compliant with modern tech
The distinctions between what money belongs to you and what belongs to the client may seem obvious. But once you’re juggling a bunch of client trust accounts, as well as maybe an IOLTA account, and accepting credit card payments, things can get murky in a hurry.
When it comes to credit cards, we always recommend using a legal-specific merchant. Legal-specific software is designed to deposit charges into the client trust account and withdraw the charge fee from the firm’s operating account.
This helps you avoid the unintentional but serious error of having a charge fee withdrawn from a client trust account or having the client’s funds deposited in the firm’s operating account before they’re earned.
Likewise, modern practice management systems can—and should—be built with trust accounting safeguards in place, such as preventing negative trust ledger balances.
And yes, trust accounts make for exceedingly intricate financial processes and recordkeeping. Automating some of that process, for instance by using linked billing and accounting systems, can save your team time and reduce the likelihood of human error. So can using legal trust accounting software to run necessary three-way reconciliation.
Legal-specific credit card merchants, trust accounting safeguards, and automation to decrease financial errors are key features to look for in any modern practice management system. Save time, stay compliant, and enjoy a little more peace of mind.
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