Law Firm Accounting Guide: 11 Steps to Boost Efficiency

Before setting up anything else, you must form an entity to formally establish your business. This process involves choosing a name, selecting a business structure, and filing paperwork required by your local jurisdiction.

Obtaining an Employer Identification Number (EIN) is especially important for hiring employees, filing employment taxes, and opening business bank accounts.

If you haven’t completed this first step, check out our guide on starting a law firm for more in-depth guidance.

If you already set up your business, proceed with the next steps.

Step 2: Familiarize Yourself with Accounting Basics

Regardless if you’re directly managing your firm’s accounting, it’s important to familiarize yourself with basic accounting terms and principles. A baseline understanding can make it easier to review reports and comprehend recommendations from your accounting team.

Start by learning about the typical accounts in a law firm’s chart of accounts. The chart will include a list of your accounts and transactions for each.

Below is a list of standard categories to know:

• Assets are items your law firm owns that bring financial value. This includes your operating account and physical equipment, like computers.
• Liabilities are items that your law firm owes. This includes accounts payable and wages.
• Equity is the value of the company after subtracting the value of liabilities from your assets.
• Revenue is the funds earned after completing legal services and before deducting expenses. This includes contingency fees and flat fees.
• Expenses breakdown specific operations costs. This includes costs for utility bills and rent.
• Compensation is items from your team’s payroll. This includes salaries and employee development costs (if included in their benefits package).

Understanding common accounts is the first step. Below are common terms to familiarize yourself with as you begin managing these legal accounts:

• A general ledger is a complete record of all transactions organized by transaction type and account.
• A client trust account is an account that solely holds unearned client funds. These are specific to law firms.
• A trust ledger is the record of transactions for individual trust accounts. These are specific to law firms.
• Client ledger is the record of transactions related to a specific client. These are specific to law firms.
• Debit refers to money going into an account.
• Credit refers to money coming out of an account.
• The double-entry accounting method is the process of recording debits and credits for each transaction. For example, if a client pays an invoice for $1,000, the amount is debited in the cash assets account and credited from the accounts receivable assets account.
• Income statements, sometimes called profit and loss statements, document a business’s revenues, expenses, gains, and losses. They determine net income by subtracting total expenses from total revenues. Income statements are used with the balance sheet and cash flow statement to holistically review a company’s financial health and performance.
• Balance sheets show a business’s assets, liabilities, and shareholder equity at a specific point in time. These help a business check that its assets equal the combined value of its liabilities and shareholders’ equity.
• Cash flow statements show the cash in and cash out during a specific period so businesses can know how much cash they have, how they use their money, and where the money comes from.

Lastly, you should also understand how business taxes work, what you’re responsible for, and potential deductions your firm can benefit from. Eligibility for tax obligations and deductions varies based on the state(s) your firm operates in.

Here are examples of common business tax obligations:

• Income tax is a tax based on money received as income. Your tax obligation differs based on your business structure.
• Self-employment tax is applicable to self-employed individuals and includes Medicare and Social Security tax.
• Employment taxes apply to businesses with employees and include Medicare and Social Security, federal unemployment insurance, and income tax.

You can also deduct business-related expenses to lower your tax obligations. Below are a few examples of deductions:

• Rent and utilities
• Business insurance
• Continuing education
• Home office expenses
• Advertising

Step 3: Learn The Nuances of Managing Law Firm Trust Accounts

Trust accounting requires law firms to meticulously track transactions coming in and out of trust accounts. If lawyers have a pooled trust account with multiple clients’ funds, they must also keep track of transactions made with each client’s funds. Trust account funds must also remain separated from all other funds.

Many lawyers are required to set up Interest on Lawyer Trust (IOLTA) accounts depending on the state they operate in. Interest earned on IOLTA accounts is sent directly to local Bar Associations to support charitable legal services.

Note that all IOLTA accounts are trust accounts, but not all trust accounts are IOLTA accounts. If you’re required (or would like to) set up an IOLTA trust account, double-check that you’re setting up the correct account with your bank.

At least quarterly—ideally monthly—law firms must complete three-way trust account reconciliation. This is the process of reconciling your bank statement with your client trust account ledger and individual client ledgers. If statements don’t match, your firm must make corrections and ensure everything is accurately logged.

Failure to keep accurate records may lead to sanctions for your firm, even if the mistake is the fault of your bank or accountant.

Step 6: Open Your Accounts

The next step is to open all of the accounts needed to operate your law firm. This includes the following:

• A business checking account that will serve as your operating account. It will hold operating funds like salaries, office rent, and anything else necessary to manage your law firm.
• A business savings account that will hold funds for future payments, taxes, emergencies, and other funds you don’t need in the short term.
• A client trust account, which holds client funds from unearned advanced payments.
• A corporate credit card account, which provides card(s) to use for business purchases. Corporate cards help avoid reimbursement issues from using personal cards for business transactions.

Ask your bank the following questions to help find the right account(s) for your law firm:

All accounts

• What are the minimum balance requirements for each account?
• What fees are associated with each type of account?
• What cash management services do you offer?
• What security measures do you have to protect client information and funds?
• What integrations does your bank offer with third-party accounting and financial management software?
• What point of sale system(s) do you support?

Trust accounts

• Is your bank familiar with the law firm trust accounting process and IOLTA regulations?
• Do you currently have clients with IOLTA trust accounts?
• What documentation does your institution provide to comply with trust accounting and IOLTA requirements?

Corporate credit card account

• How do you determine credit limits?
• How many cards can we issue to our team?
• Does your card have a rewards program?

If you’re required to open an IOLTA account, your local Bar Association may have a list of recommended financial institutions to work with.

 Step 7: Pick An Accounting Method

The main accounting methods are cash accounting, accrual accounting, and a hybrid of both methods. For example, some businesses use different methods based on the account or type of expense.

The ABA supports law firms that use the cash accounting system and opposes legislators who previously tried to impose required accrual accounting for several personal service businesses.

Although that legislation did not pass, we recommend checking tax laws for the upcoming tax year and consulting with an accounting professional to ensure you choose a compliant accounting method. For example, businesses filing taxes for 2024 can only use the cash method if receipts from the past three years do not exceed $30 million.

We’ll go over the cash and accrual accounting along with the pros and cons of both below.

Cash Accounting

Cash accounting, or cash basis accounting, is when a firm reports transactions only when cash is received or paid out. This is the simpler method of the two and is commonly used by small businesses. It also allows you to see how much cash you have in real time.

During tax season, those using cash basis accounting are generally only required to report on income received and expenses paid in the year they were received or paid.

However, cash accounting may not accurately reflect your finances since it does not account for accounts receivable or payable. For example, you may appear to have more cash than you have if outstanding payments are owed to vendors. This is a contributing factor of why the general accounting principles (GAAP) does not find cash accounting acceptable. It can also be complicated to switch from cash accounting to accrual accounting.

Accrual Accounting

Law firm accrual accounting is when your team reports transactions when they are earned rather than when cash is deposited or withdrawn. For example, if your payroll period ends on Friday, but you don’t pay employees until the next Monday, you will still record that transaction on Friday.

You may want to consider this method if you’re planning to grow a large firm. Businesses must use accrual accounting if it is publicly traded or receiving federal funding. Some investors also prefer accrual accounting since it more accurately records income and expenses when they were earned.

While accrual accounting is great for looking ahead, it’s not an ideal method for monitoring your cash flow or seeing how much cash you have. It’s also more complex and may require additional accounting staff to manage.

Law firm accounting is significantly complex, given the nuance and detail needed to track transactions. We’ll go over common errors and tips to avoid them.

Revenue Leakage

Revenue leakage is when a company has earned money but didn’t receive it due to a lack of cost control. Just like a leaky pipe, leakage can spring from a number of factors:

• Failing to report on all billable hours
• Unclear billing policies
• Inconsistent pricing or billing practices
• Data entry errors due to inefficient processes

How to avoid: Establish and enforce clear billing and expense tracking policies across all clients.

Commingling Funds

Law firms must not commingle client trust account funds with funds from other accounts. For example, you can’t use money from trust fund accounts to pay off utility bills if you haven’t earned that money. Trust funds belong to the client unless they are earned or needed for client-related fees. Anything leftover after services are complete will go back to the client.

How to avoid: Use trust accounts as sparingly as possible, keep physical client trust records separate from other financial statements, and maintain diligent records for all transactions.

Failing to Differentiate Revenue and Income

Although these terms may feel interchangeable, they’re different. Revenue is the total amount of money a business has earned. Income is the amount of earnings left over after deducting expenses.

This differentiation can get tricky for law firms. Funds from a paid client invoice are fully considered revenue. However, these funds do not fully count as income.

You must first apply money from the paid invoice toward incurred costs. For example, if your firm paid court filing fees for the client, a part of their paid invoice must cover that cost. After covering client expenses, the leftover amount is considered income.

How to avoid: Keep detailed records of expenses incurred for each client’s legal matter to accurately cover costs once you’ve received payments.

Inaccurately Tracking Time, Mileage, and Other Data Discrepancies

Manually tracking hard and soft law firm expenses can become time-consuming. Even if you use apps or other solutions to track expenses, it can be tedious to consolidate data into one spot.

However, failing to track these expenses can lead to missed billable hours. If your team does not have a clear time tracking policy or a clear agreement with the client, you may also have issues properly billing for that time.Engaging in block billing can further complicate these issues. Vague billing entries may invite confusion or disputes down the line.

Data discrepancies related to invoices, bills, and other financial transactions can lead to larger issues. Manual bookkeeping can also lead to small mistakes—like duplicate entries—that can lead to reporting and compliance issues down the road.

How to avoid: Invest in law firm practice management and accounting software to house and sync data on one platform.

Why is Accurate Accounting for Law Firms Important?

Accurate accounting helps law firms ensure they remain compliant with all laws and requirements, maintain accurate records to inform business decisions, and provide transparency with clients about their funds.

In addition to simply preparing tax returns and complying with relevant ethical and regulatory guidelines, law firm accounting requires advanced organization skills, trust accounting mastery, and expertise with reliable legal accounting software to optimize the process. Without this level of diligence, law firms can become vulnerable to penalties and sanctions.

Trust account management is an especially complex aspect of law firm accounting. Watch a replay of our webinar with Claude E. Ducloux to learn about the basics of trust accounting.