Accounting for law firms requires an understanding of some specifics around how to account for funds held in trust. it is easy to expose a law firm to significant financial risk in the event of an audit if the firm’s accountants or bookkeepers don’t know how to properly account for IOLTA funds. Law firm accounting is not difficult, however the most popular accounting packages aren’t up to the task “out of the box”. Quickbooks can quickly become a mangled mess that will cost hundreds, and likely 4 figures, for a good bookkeeper to fix. Quickbooks Online is even more fraught with landmines, to the point where the old school accountants and bookkeepers shy away from it like a case of bubonic plague. Xero makes it easier, but I have seen Xero files mangled beyond recognition. Beyond the somewhat tricky mechanics of these devilish but popular packages, there are a raft of errors waiting:
Co-mingling – I have heard attorneys and accountants say that trust funds are deposited into the operating account and then moved over to trust. Ok…but guess what happens? Everybody’s busy, the transfer doesn’t happen and presto there are commingled funds and an inadequate method of accounting to figure out what went where and who owns it. Once funds are co-mingled, the attorney or law firm is exposed to professional discipline in the event of an audit. But not everyone can get audited, so an attorney might do their best and hope to not get audited. In the meantime, the line between earned fees and funds held in trust gets blurred. The law firm’s financial position is unclear, and funds held in trust are inadvertently spent on operations or drawn out as owner distributions or dividends. This happens.
Many times, co-mingling funds are the product of accepting Credit Card Payments. A standard merchant account points to one account. Most attorneys are collecting payments for earned fees and retainers or funds advanced for any number of reasons; and they all go to that one account. Somebody then needs to transfer the funds appropriately. Since many attorneys are reluctant to allow staff access to the bank accounts, the transferring of funds becomes another task in the day of a very busy person. There are credit card processors that are specific to the legal industry, which allow the cashier to identify the appropriate account in which to deposit monies received. They also deduct processing fees from the operating fund to assure that the integrity of client funds held in trust is maintained.
Which leads to Inability to Reconcile. Individual client ledgers must be maintained that equal the total amount in the IOLTA account. This seems straightforward but it is very common to not have the ledgers. As a result, there is no easy way to know what is outstanding for any given client at any given time. Further, it is not uncommon to fail to reconcile the account to the bank statements, resulting in an inability to identify uncleared checks or bank fees that are charged to the IOLTA account.
Bank errors. In personal banking, banks rarely make errors. At least that’s what I grew up believing. However, banks do make errors and the attorney is responsible for everything from making sure that the IOLTA account is set up for the correct state, charging fees to the correct account (or not charging fees, in accordance with the particular agreement).
General accounting errors are another common problem that originate from improper accounting system setup and/or bookkeepers who are unfamiliar with accounting principles and the proper treatment of funds received in advance. I have seen trust monies improperly classified as revenue, resulting in an overstatement of income (and proportionately higher tax bill). Another common error is to fail to establish a liability account to offset the trust bank account, resulting in the accounting software defaulting the offset to owner’s equity to force the balance sheet to balance. Or, the liability account might be established, but without any supporting detail for the owners of the funds.
If you are reading this and you are an attorney, you owe it to yourself and your firm to go through your books looking for these specific items. If you are an accountant for a law firm and recognize any of these conditions and don’t know how to fix them, please give me a call and I will be happy to help you.