Opening your own law firm is an exciting point in your legal career, but you can’t get so caught up that you neglect the financial aspects of owning a business. To keep your company running smoothly, you must stay on top of your accounting responsibilities. Here’s what you need to know to establish and maintain an effective accounting system for your law firm. We’ll cover the unique accounting challenges lawyers face, some general best practices to follow, and the most common pitfalls you need to avoid. How is accounting for law firms different? Fortunately, most accounting concepts for law firms are relatively straightforward. The finances of service providers tend to have far fewer moving parts than those of businesses with an inventory on the books. However, there are a couple of unique aspects to law firm accounting, and managing them can be challenging. Most notably, lawyers often hold onto funds that don’t belong to them, and specific rules govern how you need to handle that cash. For example, lawyers may collect settlement funds on behalf of their clients. Not only do you have to keep these funds separate from yours and your firm’s, but even mingling them with other clients’ funds can be problematic. In addition, you may need to use clients’ funds on their behalf, in which case you must provide detailed reports about your activities to remain in compliance. That’s known as trust accounting, and you should understand the guidelines thoroughly before opening your own law office. If you make a mistake and violate the rules, it could cost you your law practice or your license. In addition, law firms sometimes pay for expenses on behalf of their clients using the company’s funds. These aren’t tax-deductible expenses and can muddy your financial records if you’re not careful. Bookkeeping vs. accounting for law firms Before proceeding further, let’s clarify the difference between bookkeeping and accounting. The two functions are closely related, and there’s often some significant overlap between them. Accountants may provide bookkeeping services, and bookkeepers frequently need to know accounting fundamentals. However, they’re still distinct, at least theoretically. Bookkeeping for a law office involves recording your day-to-day transactions and maintaining clean financial records. It’s an almost administrative task that involves relatively low levels of critical reasoning. As a result, lawyers can automate a significant portion of their bookkeeping using accounting software. Subsequently, they can often handle the aspects that require a human touch personally without much training. Conversely, accounting for law firms is more complex. It involves verifying bookkeeping data and using it to generate financial statements and facilitate processes like tax planning and cash flow analysis. Much like practicing law, accounting requires extensive training and in-depth knowledge of intricate rules. Making mistakes can lead to penalties and interest or audits from the Internal Revenue Service (IRS). As a result, it’s unwise for lawyers to attempt to handle their law firm’s accounting without assistance from an expert. It’s usually best to pay for a Certified Public Accountant’s (CPA) tax services. Best practices for lawyer accounting Staying on top of your law firm’s accounting responsibilities while providing legal services to clients can be a significant challenge. Here are some practices you should follow to minimize the burden and set yourself up for success. Open Separate Accounts Before Going Into Business Every small business owner should have a separate bank account for their personal and business activities. Splitting your funds makes it much easier to determine which of your transactions belong in each camp. Many new small business owners make the mistake of diving head first into growing their operations without taking this step. Unfortunately, that often makes filing their first tax return a headache since they must go back and sort out what belongs where. That’s challenging in any industry, but it can be especially difficult for a small law firm. Not only do you have to keep track of which transactions are personal and which are business, but you also need to know which costs you incur on behalf of your clients. If you need to go back at the end of the year and sort your financial data into all three categories, it’ll be a nightmare. As a result, you should open a separate checking account and credit card for your legal practice before you start taking on clients. Implement Job Costing Preventing messes before they occur instead of cleaning them up afterward is a common theme in many lawyer accounting best practices. One of the most important ways of doing this is to develop an organized bookkeeping system as soon as possible. For example, job costing is a strategy lawyers can use to ensure their financial records are easy to interpret and analyze. It’s a form of cost accounting that involves assigning every expense you incur to a specific project. For businesses like law firms whose operations revolve around clearly distinct jobs, it’s one of the best ways to organize expenses. It’s especially beneficial when you employ other lawyers, as it can help you set a profitable hourly rate when billing your clients. Take Advantage Of Software Continuing with the theme of setting yourself up for success from day one, make sure that you take advantage of software’s ability to streamline your accounting processes as soon as possible. At the very least, you should leverage accounting software to track your transactions. There’s no reason to manually enter transactions anymore with so many affordable options available. However, most lawyers shouldn’t settle for generic software. Attorney-specific accounting software exists, and it can facilitate many more aspects of running your business, including: Time tracking software that integrates with your invoices Client intake, scheduling, and relationship management Automatic trust account updates and reconciliations Many different solutions are available, and each can offer you a unique combination of benefits. Make sure you review them carefully and determine which tool makes the most sense for your business in its current stage of development. Consider The Cash Accounting Basis One of the most significant decisions small business owners have to make in the early days of their company is which accounting basis to follow for tax purposes. Generally, the two allowable options are the cash basis and the accrual basis. The cash basis of accounting involves recognizing revenues when you receive cash and deducting expenses when you pay them. Because it’s the easiest to implement, lawyers often prefer this method. The American Bar Association also recommends it. Meanwhile, the accrual basis of accounting involves recognizing revenues when you earn them and expenses when you incur them. That requires significantly more expertise and forces you to keep track of accounts receivable and payable. You’ll often hear that the accrual basis is worth the extra work because it’s more accurate, but that’s primarily true for businesses that carry inventories. The IRS requires companies with inventories and revenues above $26 million to use it. Meanwhile, a legal business can use the cash basis no matter their revenues, and it often represents their activities more accurately. As a result, many lawyers can avoid a lot of trouble by electing the cash basis. Stay On Top Of Your Tax Obligations One of the most significant changes you face when transitioning from full-time employment to business ownership is the loss of tax withholding benefits. As a result, you must make estimated tax payments each quarter. These payments are to cover your federal and state income taxes as well as your self-employment taxes. If you don’t make them on time or pay much less than you should’ve, you may incur penalties and interest. If you expand your operation and hire employees or structure your business in a way that involves paying yourself a salary, you’ll also have to worry about payroll taxes. These are also due throughout the year, usually bi-weekly or monthly. Ultimately, it’s unwise to try and navigate your tax obligations alone. The last thing a new law firm needs is to get on the wrong side of the IRS. Consider consulting with an accounting firm to clarify your responsibilities and ensure you’re meeting them. Get Expert Help Finally, one of the best ways to lessen the burden of accounting for your business is to pay someone to help you with it. Not only is accounting complex, but it’s also time-consuming, and you have other responsibilities. Fortunately, you usually don’t have to hire a full-time accountant for your law firm. That’s often expensive and unnecessary. Instead, consider paying for outsourced accounting services from a CPA firm. It’s a lot like businesses that engage a law firm for their needs instead of hiring an in-house lawyer. You’ll pay far less and get only what you need. Just be sure to choose a CPA experienced in providing law firm accounting services. Common mistakes As a lawyer, you can appreciate the time and effort that goes into becoming an expert in a complex field. Unfortunately, accounting and tax rules can be every bit as convoluted as any area of study in the legal industry. Since law school doesn’t cover these subjects, it’s easy for new law firm owners to make financial mistakes. Here are some of the most common pitfalls you should know to avoid. Underestimating Accounting Duties When lawyers decide to open their firm, accounting is rarely at the top of their minds. After all, you have many more exciting things to pull your attention, such as winning clients and providing services. As a result, it’s easy to make accounting a secondary priority thinking you can always deal with it later. Unfortunately, that attitude leads to some of the most frustrating accounting situations. For example, you could discover once it’s time to file your return that you owe penalties and interest for missing your estimated tax payments or that your accounting records are in such disarray that you have no idea how to untangle them. Remember, it’s always better to prevent problems than to try and solve them after the fact. If you’re planning to open your own law firm, make sure you give your accounting the attention it’s due sooner rather than later. Misattributing Transactions Whether it’s mixing up your business and personal transactions or deducting an expense from the wrong client trust account, it’s easy for law firm owners to record transactions incorrectly. As a result, you must develop a habit of performing regular reconciliations to ensure that your financial records are in order. It’s typically best to perform bank reconciliations for your business checking accounts each month. In addition, all state bar associations require law firms to perform three-way reconciliations monthly or quarterly. That involves confirming that your trust ledger, client ledgers, and trust account statement balances agree with each other. A trust ledger records all the transactions impacting your trust account. Client ledgers record those same activities but assign each one to a specific client. Mismanaging Trust Accounts Managing trust accounts is one of the unique aspects of legal accounting, and the consequences of mishandling them can be significant. Not only will you incur fines, but you could also lose your license or face legal repercussions. You might think that keeping your clients’ funds separate from your own sounds simple enough, but it’s surprisingly easy to violate trust accounting requirements. For example, many banks are unfamiliar with lawyer trust accounts. As a result, you could accidentally use a regular business checking account to store your clients’ funds, which violates trust accounting rules. As a result, you need to understand your trust account responsibilities thoroughly. Take the time to master what constitutes professional conduct. For example, you should understand all of the following: Taking funds out of trust accounts: While you must pay taxes on advance fees in the year you collect them under the cash method, you can’t take them out of your trust account until you earn them. Unfortunately, it can be hard to determine when lawyers can say they’ve earned their advance funds and retainers. Pooling client funds in one trust account: Generally, lawyers that hold relatively small amounts of money for a short time from multiple clients place them all in a single trust account. However, a significant sum from a single client should have its own. Interest on Lawyer Trust Accounts (IOLTAs): Traditional trust accounts may or may not earn interest, but IOLTAs do. However, lawyers can’t keep the interest their clients’ funds generate. Instead, IOLTAs automatically go toward charitable purposes. Once again, it’s best to master the trust accounting rules well before you go into business for yourself. It’s one area you can’t afford to make mistakes because there’s rarely a chance to fix them later. Looking for financing for your law firm? Learn more about law firm financing options.