While Law firms must follow strict compliance and ethics rules for trust management, the rest of their business is pretty simple and straightforward.  The accounting basics can help you track revenue and expenditures, better manage your time, and find key areas of your business that you can improve on. 

Accounting requirements for law firms are unique, and if a firm isn’t working with an accountant, the owner must set everything up on their own and know what they’re doing. 

Legal Accounting Components 

Law firms, more specifically legal accounting, have many moving parts and components. You need to manage: 

  • Time and billing, which is your “inventory” 
  • Advanced client costs 
  • Retainers 
  • Trusts and trust activities 
  • Operating expenses 

Terms you’ll need to be familiar with, as relates to law firms, are: 

Profit and Loss Report Sections 

A profit and loss statement has a few terms that you’ll need to know: 

  • Revenue/Income: Revenue is recognized when it’s realized, not when it’s in invoices waiting to be paid. This is referred to as Cash Basis accounting. Most law firms run their financials on a cash-based system. Canada is the exception. Cash is realized when you receive the money and accrual is realized when the transaction occurs or the invoice is made. 
  • Cost of Goods Sold (Advanced Client Costs): Your cost of goods sold is what you paid on behalf of the client that needs to be reimbursed. Expenses can be added to your balance sheet as Advanced Client Costs or on a Profit Loss report as cost of goods sold (reimbursable client costs). 
  • Firm Expenses: General expenses during the course of business, including rent, payroll, contractors, professional services, software, office expenses, supplies, and marketing. 

Categories on a Balance Sheet 

You’ll also have categories on your balance sheet which can be confusing, such as: 

  • Assets: An asset is something your firm owns, such as cash in your bank account, furniture, security deposit, accounts receivable, and the like. 
  • Liabilities: A liability is something your firm must pay, which can include loans, accounts payable, client trust funds, and more. 
  • Equity: Each owner’s value of the firm’s assets from net profits and contributions. 

Setting Up Accounts 

A Law firm’s chart of accounts (also referred to as a General Ledger) is specific to law firms. General ledger accounts include: 

  • Client Trust Bank Account 
  • Client Trust/IOLTA Funds – Liability Account on Balance Sheet 
  • Reimbursed Client Expenses or Income you recovered for client expenses paid on your behalf 
  • This can be an Asset account on the balance sheet or an Income account on the Profit and Loss Statement 
  • Legal Fee Income  
  • Reimbursable Client Expenses – Any expenses you incurred on behalf of the client. 
  • This can be an Asset account on the balance sheet or an Expense or Cost of Goods Sold account on the Profit and Loss Statement 
  • Unrecovered Client Expenses 
  • These are important to track especially if you do personal injury cases. If you lose a PI case and will not recover expenses, these need to be re-booked on your financials to have an accurate picture of client expenses.  

Accounts will fall into five categories: 

  1. Assets 
  2. Liabilities 
  3. Equity 
  4. Income 
  5. Expenses 

Your chart of accounts will have a profit and loss statement, which includes income, cost of goods sold and expenses, and your balance sheet will have assets, liabilities, and equity. A cash flow statement will have all of these categories. 

Financial Reporting 

Preparing monthly reports on a regular monthly cycle is important for running a successful business.  Reports provide an in-depth look at the financial health of your firm and help you identify areas of improvement. Regular reporting can help you: 

  • Address financial issues before they escalate into bigger problems 
  • Make data-backed decisions 
  • Reach your firm’s growth goals 

Monthly financial will include: 

  • Profit Loss Report (Income Statement) with prior months or years for comparison 
  • Balance Sheet 
  • Owner Draws or Distributions (money you have taken out of the firm) 
  • Expense Detail 
  • Trust 3 Way Match Report Reconciliation Report 
  • Accounts Receivable Aging Summary (money on the table) 
  • Work in Progress (future revenue) 
  • Cash Flow Report 

At CPN Legal, we can help you make sense of the data and start adding them to your key performance indicators (KPIs), such as billable hours, realization rates, and utilization. 

Reports can be split into income and expenses by each attorney, practice area, and even location to help you better understand your firm’s financial health.  

Reporting will give you the data you need to improve your processes and billing, track your goal progress, and improve your firm’s financial stability. 

Retainers and Trust Accounting 

Retainers are good for business and cash flow. Your client gives you the funds upfront, but this also comes with management requirements. Trust account management is required by the ABA, and your software will need to: 

  • Show all work on invoices by timekeeper 
  • Maintain a history of cash in and out of the client’s trust account and show on client invoices 
  • Maintain individual client trust ledgers with full history 

Trust accounting requirements are complex, but working with a trust accounting expert, such as CPN Legal, will ensure you stay in compliance with your state bar. A few of the requirements are: 

  • Maintain a separate trust bank account(s) 
  • If you operate in multiple states, you will need a trust account set up for each state 
  • Record Client funds in a trust liability account 
  • Maintain Individual ledgers for each matter or client 
  • Produce a Monthly trust reconciliation and 3-way match reconciliation  

Clio is designed to handle all trust accounting state bar rules and keep you in compliance. 

Profitability/Areas of Focus 

Firms should focus on a forward-thinking mindset, and knowing the components of financial reports can help. 

  • Cash flow forecast report looks at Cash balance in your bank accounts (not trust accounts), monthly nut, upcoming expenses, A/R and WIP. 
  • Ratios look at Profit and loss as a percentage of your total income. For example, what percentage of your income is going toward expenses? 
  • Work in Process (WIP): Billing goals and utilization rates. 
  • Billing Realization rates: Is all your time getting billed or are you in the habit of discounting/writing off before you send a bill?
  • Collection Realization rates: Look at your collections. What happens from the initial time work is performed all the way through getting paid? 
  • Budget reports in QuickBooks Online: Learn to love these reports and use them as planning tools. 

Realization Rates 

A firm’s billing and collection realization rate measures its percentage of billable hours that are actually invoiced to clients (billing realization) and collected (collection realization). It provides valuable insight into how much of your work is actually being transformed into revenue. 

According to Clio’s Legal Trends Report, firms had a realization rate of 81%. What this means is that 19% of billable hours were not invoiced or collected on. 

Realization rates provide insight into your firm’s billing efficiency, pricing strategy and overall financial health. 

At CPN Legal, we understand the complexities of legal accounting, from managing time billing to handling trusts and client expenses. 

Ensure your firm’s financial health and streamline your billing processes with our team by your side. Contact us today to learn how we can support your firm’s success.