Law Firm Accounting Guide: Tips and Best Practices

Legal accounting and bookkeeping are an essential part of any law firm day-to-day processes. The only way to avoid running afoul of financial laws and regulations is to have strong legal accounting and bookkeeping practices.

By learning the principles and best practices of legal accounting and bookkeeping, you can effectively strengthen and protect your firm's finances from preventable problems. In this law firm accounting guide, we take you through law firm accounting and financial management basics to cement your knowledge and present valuable new information. We cover all the key aspects involved in both practices and explain strategies to help you apply this knowledge to your firm's benefit.

For valuable insights, be sure to check out the podcast episode "Transform Your Law Firm's Financial Systems" with Molly McGrath, Founder and CEO at Hiring and Empowering Solutions.

Law Firm Accounting: The Main Definitions

Law firm accounting involves the systematic recording, reporting, and analysis of financial transactions related to legal services. It is an essential part of any law firm's operations and provides an accurate record of income and expenses. The main types of accounting associated with law firms include Trust Accounting, IOLTA, Double-entry Account, and Three-way Reconciliation.

Understanding these terms and how they relate will help law firms properly manage their finances. Additionally, maintaining accurate books helps ensure that all financial information is correct and up-to-date.

Trust Accounting

Trust accounting is the bookkeeping of clients' income and expenses that are held in trust. This type of accounting for law firms may include assets from settlements or retainers fees. These funds held in a trust are not the law firm's property but are individuals or institutions known as trustees. 

While each account is managed in accordance with the law of the state, they have common rules guiding them. 

1. These funds should not be used for law firm operating expenses. 
2. Client funds must be deposited into a client trust account. 
3. You cannot deposit law firm money in a client's trust account.  
4. Your firm may not earn interest on the account. 
5. You cannot keep earned fees in a client's trust account. 
6. You cannot withdraw disputed money for payment of firm fees. 
7. You must fully account for trust monies and assets when a client requests. 
8. Firms must reconcile trust accounts regularly.

IOLTA

IOLTA stands for Interest on Lawyers Trust Accounts. These accounts include pooled client funds from settlements, retainers, and other client funding sources. Interest is transferred from the account and used for social justice programs, such as legal aid services. Like the trust accounts, the rules vary to keep in mind. They require meticulous accounting to keep clients' funds separate. 

1. Law firms cannot borrow or use these funds.
2. Law firms may remove funds from the IOLTA trust bank account when they have earned them. 
3. Interest can be made on these accounts. Earned interest does not belong to the law firm.

Double-Entry Accounting

Double-entry accounting aids in the detection and prevention of accounting errors. In double-entry accounting for law firms, each financial transaction results in two transaction entries. These transactions are recorded on equal sides, known as debits and credits. Debits and credits combine to form a balance sheet comprising assets, liabilities, and equity. They must always equal out on all accounts. 

Three-Way Reconciliation

Most bar associations require law firms to comply with regular three-way reconciliation. Reconciliation protects against financial issues and uncertainty for both clients and law firms. Three-way reconciliation requires bank account balances and book balances to match. It also requires the bank account and book balances to match client ownership details. 

Three-way reconciliation is generally conducted every 30 to 60 days, depending on the state. You can do it manually or by using powerful legal accounting software to assist law firms in meeting this requirement. Law firms are responsible for balances that do not match up, regardless of fault.

Types of Law Firms Accounting and How They Compare

The Key Difference Between Law Firm Accounting and Bookkeeping

Both accounting and bookkeeping for law firm are essential for success, and they share some similarities. Although they are different processes, they complement one another. Generally speaking, law firm bookkeeping is only concerned with organizing recording financial transactions and data. Accounting, on the other hand, deals with interpreting and presenting this financial information to relevant parties.

With financial data, legal accountants present big-picture information and give comprehensive and specific reports of a firm's financial health. These data are valuable for a law firm's future sustainability and profitability.

Bookkeepers should be up to speed on the rules and regulations of the jurisdictions they work in and have accounting software experience. Legal accountants also need to be intimately familiar with the relevant rules and regulations and be comfortable using different types of software. Accountants should also be able to provide a law firm with professional counsel to help the firm grow financially.

Top 11 Law Firm Accounting Best Practices

Even with your busy schedule of cases and clients, you can master law firm accounting and financial management. Although daunting for some, the principles behind law firm accounting and financial management are based on simple financial management concepts that are not as difficult to master as you might think.

As you learn more about the process, you will likely find that you already understand law firm accounting and financial management. But no matter how much knowledge you hold, this guide will help you attain a high level of fluency in both practices.

1. Sort Out Your Budget

Your budget will act as one of the primary guiding forces of your law firm. Hence, working out a comprehensive budget that captures every aspect of your business expenses is important. Mastery of accounting and financial management practices will help immensely. With a well-thought-out budget, you will be prepared to:

• Make and execute realistic goals
• Monitor cash flow and expenditures
• Account for discrepancies

The right budget management software is essential for law firms. Clio Manage and other programs help firms organize their financial activities, from the expense and revenue tracking to managing billables.

2. Figure Out What Types of Bank Accounts You Need 

All law firms must have bank accounts to handle the flow of revenue, payments, and other funds. Generally speaking, most lawyers use three types of financial accounts:

• IOLTA accounts
• Checking accounts
• Savings accounts

Many law firms have all three accounts or more, depending on their needs. Proper law firm accounting and financial management can help you decide which ones are right for you and which banking institution is suitable for your firm.

When deciding which accounts you should open for your law firm, you'll want to get answers to a few key questions. You should pose these questions to the institution handling your business bank accounts:

• What are the fees involved, and how can they be avoided?
• Are business savings accounts available?
• Are business credit cards and lines of credit available?
• Are IOLTA and other types of trust accounts available?
• Can I designate separate users to handle certain banking matters?
• What type of security and fraud protection do you offer?

Comparing different banks' answers to these questions will help you decide which institution and account are right for you. Shop around and ask lots of questions.

3. Open a Business Bank Account

A bank account allows tracking all incoming and outgoing funds, which is necessary for accurate record-keeping. It helps to keep personal and business finances separate. Having a separate business account allows for greater control over the accounting of clients’ funds. It provides a more secure way to manage finances. It also establishes credibility with existing and potential clients, showing that the law firm is taking its financial affairs seriously. 

To open a business bank account, you will need the necessary legal paperwork, such as the Articles of Incorporation and Employer Identification Number (EIN). You may also need to provide proof of address and identification documents. Once the account is open, it is important to manage it carefully by regularly reconciling accounts, tracking expenses, and paying bills on time.

4. Keep Your Accounts Separate

There is no room for error when blending client funds with law firm funds. It pays to have an effective system that will prevent this from occurring. By keeping your money separate at all times from your clients' and strictly following trust administration rules and guidelines, you'll sidestep a whole host of problems down the line.

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5. Specify Your Accounting Methods

Specifying your accounting methods and needs is another important step to mastery of legal accounting and financial management. Law firms use either accrual or cash accounting. The appropriateness of one method over the other highly depends on the characteristics of your firm.

Cash Accounting

Cash accounting is the simpler of the two. It provides for recording cash as revenue when your firm receives it. This means once a payment hits your bank account, it is taxable. The same holds for expenses. They aren't counted as such until money leaves your account. This method does not recognize various payment accounts, such as accounts receivable and payable.

One of the principal benefits of using the cash accounting method is its simplicity. This type of accountancy gives you a clear look at your current financial situation. But it does not take into account cash coming in later. However, this could work to your benefit. With cash accounting, you don't have to pay taxes on earned money until it has been deposited into your account. This can help you defer tax liability until you are in an optimal position to address it.

Accrual Accounting

With the accrual method, on the other hand, you enter an expense or revenue the moment it is incurred or earned. For example, when you invoice a client for services, the money they owe you is entered into the books as revenue. The same is true for expenses and liabilities. Once your firm receives a bill, the expense goes on the books.

With this method, tax liability attaches before funds are even received. And although accrual accounting gives you a good idea of your future income and expenses, it does not provide as clear a picture of your cash flow situation as cash basis accounting. This is a more appropriate accounting method for large firms with high client turnover.

6. Hire a CPA

Lawyers are incredibly competent professionals. However, taking on tasks above and beyond your duties is never a good idea, especially accounting and financial management tasks. As with the law, too much can go wrong if you don't have the right professional in charge. Let a competent, experienced professional or company handle things is always better.

How to Hire Staff for Law Firm Accounting Jobs

You want a professional with ample experience handling law firms' accounting ins and outs—one who knows jurisdictional rules and can provide valuable guidance to your firm. To ensure you make the right choices, developing a thorough job description that outlines the skills and experience required for each position is important. Then you do the following: 

1. Make sure that the people you hire possess the necessary qualifications, including experience in financial analysis and accounting software and knowledge of legal terminology and procedures. 
2. Create a transparent selection process that allows you to compare applicants and their qualifications. 
3. Ask open-ended questions about their experience and skills during the interview to verify their credentials, which will help you gain insight into the candidate’s strengths and weaknesses. 
4. Review any references they provide and check with the state licensing board to ensure they have the appropriate certifications. 

After selecting a candidate, provide adequate training to ensure they are prepared to handle the job. Offer competitive wages and benefits packages to qualified candidates once you have finalized your selection.

Questions to Ask When Interviewing a Bookkeeper

Finding the right staff member requires asking the right interview questions. You need to know specific things about your potential hire to honestly know if they are up to handling your bookkeeping needs.

Questions to ask potential bookkeeper hires include:

• Do you know the relevant jurisdictional rules and regulations?
• What experience do you have with accounting software?
• What is your experience with preparing financial reports?

You will also want to inquire about their relevant education and training in bookkeeping and financial account management.

Questions to Ask When Interviewing a Legal Accountant

Some key questions to ask potential legal accountants include the following:

• Are you up to speed on the rules of our firm's jurisdiction?
• Do you have experience with similar law firms?
• What benefits can you provide to a firm like mine?
• Are there any special services or experiences you can bring to the table?
• Will you be able to provide recommendations and guidance?
• What accounting software do you have experience with?

You should also inquire into each candidate's education and training related to legal accounting.

7. Study Law Firm Accounting Reports Regularly

Top-of-the-line law firm accounting practices generate regular reports of activities. By studying these reports, you will gain valuable insight into your firm's operations and be able to make effective decisions for your firm. It's easier to spot opportunities and potential problems and take effective, appropriate action if you regularly read your law firm accounting reports.

8. Check Your Tax Filings

Ensure all tax filings are completed correctly and on time to avoid potential penalties or legal issues.

9. Automate Your Budgeting

Create a budgeting system and setting up automated reminders to help keep spending in check

10. Keep Up with Financial Trends

Review financial statements and study trends in the industry to help identify areas of improvement or opportunities for growth regularly. 

11. Keep Track of Miscellaneous Expenses

Don't forget miscellaneous expenses. Examples of these expenses are fees for transportation, court filings, expert witnesses, transcripts, medical records, etc. 

How Accounting for Law Firm Can Benefit Your Business?

Although the basic principles behind accountancy and bookkeeping are easy to grasp, the execution of both requires time. That's why law firms employ dedicated professionals and software to handle financial matters for their businesses. Doing so provides them with the following benefits:

It Keeps Your Law Firm Compliant

Law firms are under a particular duty to maintain compliance at many levels, most notably with regard to client funds and other financial matters. They also face tax-compliance issues at the state and federal levels and municipal taxes.

Legislative bodies, the American Bar Association, and state bar associations have created protective rules stipulating how lawyers carry out their duties to their clients.

It Helps You Grow

A strong accounting practice will also allow you to plan strategically for the future. Clearly presented financial data will help you identify areas in your business accounts that may need tweaking for optimal functionality. This data will also aid in determining the financial feasibility of planned projects or actions, such as taking on a particular client, hiring more staff, or acquiring real estate and other assets.

To learn more about financial management and law firm growth, watch our podcast, where Sasha Berson and Ryan Kimler discuss increasing a law firm's revenue by optimizing numbers.

You Always Know Where Your Money Is

Successful law firms know everything about their money, from where it came from to where it will go. If you don't have a strong accounting practice handling your affairs, you might be surprised at all the expenses you incur and pay each month. You may also be surprised by how much revenue comes in.

It Protects Your Reputation

It takes years to establish reputation management for lawyers and one second to destroy it. Law firms are held to a high standard and suffer greatly when errors occur, even when the errors are unintentional and understandable. Law firm accounting helps you keep your firm's name reputable and clean.

Mistakes to Avoid in Law Firm Accounting and Financial Management

Accounting and financial management mistakes can threaten the well-being of any law firm. Fortunately, you can easily avoid many of them if you know which types of errors are the most common.

Not Distinguishing Between Revenue and Income

Without a professional accountant, you risk mixing up revenue and income, two different types of proceeds. Revenue refers to the money, payments, and proceeds your firm receives. On the other hand, income refers to what is left over after the firm's costs and expenses have been deducted from the revenue. Taxes, property expenses, legal dues, and payroll are typical expenses law firms must deduct from revenue to get income. Mixing up the two can give you a false picture of your firm's financial health.

Borrowing From IOLTA

Borrowing from IOLTA is not only a mistake but also against the rules. Client safety is one of the main concerns of bar associations. The bar will do everything possible to make sure client funds are safe. Borrowing from a trust account puts these funds at risk. Borrowing is also a red flag for potential insolvency or other financial problems a law firm may be going through. In other words, if your law firm even considers borrowing from its IOLTA account, you may not be in the best position to handle clients. You should take action to remedy your finances.

Recording Trust Accounts as Income

Trust accounts are not income for your firm. Recording any money still in a trust account as income is a glaring error and is also against the rules. You may count funds in trust accounts as income until you have earned fees for services rendered.

Messing Up With Trust Accounts

Mistakes with trust accounts are common but not always forgivable. Disbarment and other sanctions are on the table when a firm messes up with a trust account. Various ways these errors manifest themselves include:

• Erroneous deposits
• Accidental misuse of client funds
• Commingling of funds
• Failure to accurately report accounts

Law firms must know that there is essentially no wiggle room for errors. Trust account liability almost operates like strict liability, where simply committing an act is proof enough for guilt. No reasoning behind the action can absolve the actor.

Fortunately, software is available to help monitor for errors and prevent them from happening in the first place.

Data Entry Mistakes

It is sad but true that some of the most troubling errors law firms face are simple data entry mistakes. Unfortunately, their consequences are not always so simple and can affect significant portions of law firm business.

Transform Your Law Firm's Financial Systems with Molly McGrath, Founder and CEO at Hiring and Empowering Solutions

In the episode, Sasha and Molly delve into revolutionary methods for improving law firm finances. Molly emphasizes the importance of investing in team development, adopting innovative financial models like Profit First, prioritizing relaxation and system refinement, and restructuring the hierarchy to empower support staff. These strategies collectively contribute to boosting firm income and overall financial success.

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Molly McGrath

Hiring and Empowering SolutionsHiring and Empowering Solutions

Molly McGrath is the dynamic Founder and CEO of Hiring and Empowering Solutions, a leading consultancy specializing in optimizing talent acquisition and development strategies. With a deep understanding of the evolving workforce landscape, Molly is passionate about helping organizations attract, engage, and retain top talent. Her expertise lies in designing inclusive hiring practices, fostering diverse and equitable workplaces, and creating empowering development programs that drive individual and organizational growth.

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Law firm accounting and financial management are pillars all law firms should rest on. There are far too many regulations and opportunities for error for an active firm not to have quality methods of handling its legal and financial accounting needs.

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