Five Pitfalls Of Legal Accounting
Mention accounting in front of a lawyer, then take a step back and appreciate the look of terror that comes across their face. You can trust me or try it for yourself, but just mentioning the word almost always strikes fear in lawyers’ hearts everywhere. The reason why is simple. Lawyers are not accountants, but when it comes to running a law firm, especially a small law firm, legal accounting is extremely important. The problem is – as important as accounting is to a law firm, it can be equally as challenging.
First, it’s important to understand why accounting is so important to law firms. First and foremost- COMPLIANCE! In the legal world, compliance is key, and a law firm’s accounting is no different. Failure to remain compliant could result in stiff penalties for law firms, even disbarment.
Second, is a firm’s income. If your firm’s accounting isn’t up to snuff this means you could fall victim to leakage. This means money that should end up in your pockets could very well remain in the pockets of your client or other service providers based on poor accounting practices.
Third, is the continued success of a law firm. If a firm effectively manages their accounting, they can begin to form extremely valuable business intelligence surrounding some of their more successful practice areas and allocate the appropriate resources to ensure the greatest levels of success for the firm.
#1 – Client Trust Fund Accounting
Using retainers to secure cash flow from clients is a common practice for law firms. This means that funds may be in the firm’s possession, but they do not belong to the firm until they have been earned.
Complications for law firms arise as they need to track client ledgers individually while still keeping all trust funds pooled in one bank trust account. Law firms need to ensure that one client’s funds are not commingled with another and that these client funds are not used to pay for the law firm’s expenses.
One way firms can avoid issues often associated with client trust fund accounting is to utilize legal-specific accounting software. In addition to the prevention of commingled client trust funds, legal-specific accounting software can help a firm prevent the following trust fund accounting pitfalls:
- Overdrafting the client ledger at the transaction level.
- Posting transactions to an inappropriate account such as an income or expense account.
- Falling out of compliance by neglecting the 3-way reconciliation process.
#2 – Proper Accounting of Case Costs
When practicing law, costs are incurred from the outset of every case. Eventually, all of these costs are billed to the client. It is required that all costs are accounted for properly. This sounds simple enough until you understand that not all costs can be treated the same.
This is where law firms can run into trouble. Depending on the case type, your accountant may advise you to treat case costs as “Advanced Client Costs” or “Reimbursable Client Costs”. Advanced client costs need to show up as an asset on the firm’s Balance Sheet, while reimbursable client costs need to be recorded on the Profit & Loss Statement. Failure to do this accurately and consistently every time you book an expense can result in IRS compliance issues. In addition to this, law firms need to make sure any cost incurred, be it by cash, check or credit cards, gets allocated to the appropriate matter contemporaneously or it will not get billed — resulting in a net loss to the firm.
#3 – Differentiating Income and Revenue
When an invoice is paid, a portion of the revenue must first be allocated to incurred costs. This portion must be recorded separately and not considered income. Firms who have difficulty in separating revenue that covers incurred costs from their actual income will have inaccurate books, battle compliance issues, and experience difficulty recognizing which cases have become more valuable to the firm.
#4 – Data Entry Errors While Syncing Legal Billing & Accounting Systems
It is imperative that a law firm’s billing and accounting systems use matching sets of data. The problem is that more often than not law firms use two disparate systems for their accounting and billing. This means that all financial data must be entered twice, but must be done accurately across both systems. Failure to accurately sync these two systems will create bookkeeping issues, resulting in billing complications or ethics violations.
One way that firms can avoid these issues rooted in billing and accounting systems not being in lockstep with each other is to utilize a practice management system that includes both billing and accounting functions in a single data set.
#5 – Understanding Where The Money Came From
Nobody has ever said being a lawyer is easy, it becomes that much more difficult when a lawyer decides to manage a firm. There’s much more to think about than just a caseload. The lawyer needs to make a transition from a lawyer to lawyer/businessman or woman.
Simply tracking income without understanding which practice areas it came from is really a major disservice to the firm. Making decisions about the business of your firm without accurate data can lead to serious missteps that result in a loss of revenue. When firms are able to track their income by case type it can open new business opportunities by creating valuable business intelligence around different case types, enabling the firm to spend their marketing dollars and resources more effectively.
Making the jump from lawyer to managing a law firm can bring on new challenges. Legal accounting is surely one of the largest. While it can be one of the largest and intimidating challenges a firm faces, if the right solutions are put in place to help manage a firm’s accounting it can easily transition from a challenge to an opportunity to grow the firm.
About the Author
Dr. Rick Kabra is the CEO of CosmoLex, a leading provider of web-based legal practice management software. Clients rely on CosmoLex as their fully functioning, virtual law office – that lives in the Cloud. CosmoLex’s comprehensive menu of capabilities has replaced the hodgepodge of separate programs and manual clerical work that used to be the norm at law firms. Rick’s vision of offering a “Total Law Practice Solution” in a single login — a platform upon which lawyers can manage & run an entire practice is becoming a reality with each passing day.