What Do Lawyers Need to Know about Accounting and Client Funds?
Unlike many other business owners, lawyers need to understand two types of accounting: business accounting and legal accounting.
Although legal and business accounting certainly overlaps, there are critical distinctions as well—particularly when it comes to handling client funds.
Different types of law firm accounting
First, it’s important to understand the differences between business and legal accounting, as well as the different areas within legal accounting.
Business accounting
Business accounting is what law firms have in common with other businesses. This includes the expenses of running a law practice—such as overhead, payroll, and the rent for the office—assets, liabilities, and equity.
Additionally, business accounting offers important insights for law firms as to what the firm’s overall financial health looks like and is a key component in creating a long-term business plan.
Legal accounting
Legal accounting is, of course, specific to law firms. It encompasses matter cost and income accounting—client costs, reimbursements, and fee income—as well as fee advances and retainer accounting.
Retainer accounting refers to unearned income held in trust accounts and funds held in escrow for disbursement, as in personal injury cases. In accounting terms, retainers are liabilities—they are funds that haven’t yet been earned and still belong to someone else (the client).
Keep your operating and trust accounts separate
When handling client funds, it’s essential that law firms keep their operating and trust accounts separate.
The money in a trust account still belongs to the client. Therefore, law firms can’t access this money until they’ve earned it. The operating account, on the other hand, belongs to the law firm.
Although money may be moved from the trust account into the operating account once work is completed and billed for, these two accounts are distinct and must be treated as such.
Deposit funds in the correct account
It’s also important that lawyers understand which funds belong in which account.
Trust accounts
The funds that can be deposited into a trust account are generally limited to settlement funds, which will be distributed to one or more parties (commonly found in personal injury or real estate), and retainer fees for work to be done.
Think of these retainer fees as unearned income. They don’t belong to the law firm until the work has been done on the matter and billed for.
Additionally, third-party funds, judgment funds, and advances for cost should also be placed in a trust account.
Operating accounts
While the above funds need to be deposited directly into a trust account—and must not first be placed in an operating account—there are also funds that may only be deposited in an operating account.
Earned income belongs in an operating account. For instance, if you do work for a client on a matter and bill for that work, then after enough time has passed for the client to reasonably review and object to the bill, you can and should transfer the billed funds from the trust account to the operating account.
Ultimately, any funds not related to the client should be deposited into the operating account. Likewise, the operating account is the account from which business expenses should be paid.
Track individual client ledgers
All client money held in trust must be tracked. Failing to do so is an ethics violation—and also poor bookkeeping.[1] Each client or matter account needs its own ledger, with individually tracked balances and transactions.
On the upside, tracking individual client balances means that you can be aware of when retainers are getting low and need to be replenished. In this manner, you can avoid over-drafting a client ledger.
Avoid over-drafting a client ledger
If you don’t use a legal-specific, single-platform practice management system, over-drafting a client ledger can result in an ethics nightmare.[2] Over-drafting one client account often means funds get automatically pulled from another client account—which results in the law firm accessing unearned client funds.
Fortunately, if you use a single-platform legal billing and accounting system, it should come with safeguards in place to prevent over-drafting.
Don’t commingle funds
Commingling funds is an ethics violation and it occurs any time individual funds aren’t separately maintained, specific to their individual matter—regardless of whether funds are being mixed with other clients’ funds or the law firm’s.[3] The one exception is when a law firm needs to cover service charges related to the account.
Commingling funds can take a variety of forms, including buffering the trust account with law firm-owned funds, over-drafting a client ledger, or mixing client funds.
Vet your merchant provider
Accepting credit cards is effectively a necessity in today’s world of instant, electronic payment options. However, if law firms don’t use the right merchant provider, they can land themselves in trouble.
We strongly recommend working with a legal-specific merchant provider. Generic merchants will withdraw processing fees from the same account they deposit funds into. Retainer payments made by credit card must be deposited into the trust account, but processing fees must be withdrawn from the operating account. Law firms need to work with merchants who can handle these distinctions.
Additionally, it’s worth checking to see if the merchants can integrate with your legal billing platform. After all, you might as well save your team some time and effort when possible.
Keep up with reconciliation
Regular reconciliation helps law firms catch errors while they’re still relatively fresh—and thus easier to untangle and fix. It’s also required for trust accounts. While the required timeline for reconciliation varies by jurisdiction, if you’re ever subject to a trust audit, you’ll need to produce these records.
Historically, reconciliation was a dreaded, time-consuming task, but a modern legal billing and accounting system can do the heavy lifting for you. And while this includes three-way reconciliation, it’s also vital that your firm maintain proper reports.
Single-platform accounting and billing solutions
Although legal accounting isn’t exactly a walk in the park, today’s legal tech can relieve your team of a lot of work and worry.
A single-platform legal accounting and billing system should come with safeguards to help prevent trust accounting violations and keep your firm compliant. Likewise, these systems can run reports and reconciliation—including three-way reconciliation—for you.
They also offer legal billing solutions, such as evergreen retainers, which automatically notify clients to replenish once a balance falls below a certain threshold.
For a busy legal team, a good, single-platform practice management system can help keep you compliant and clear a significant amount of time in your schedule for actually practicing law.
References
1. Model Rules on Financial Recordkeeping – Preface
2. IOLTA and Client Trust Accounts
3. Rule 1.15 Safekeeping Client Property – Comment