Law Firm Accounting: It’s Not the Same

When vetting both accounting professionals and legal accounting software, having a basic understanding of the key distinctions between general business accounting and legal accounting can be critical to making the right decision for your firm.

Your accountant may be great at handling small business accounting, but you need to be sure your accountant understands the differences between law firm accounting and other small business accounting requirements. It is your responsibility to make sure your books are correct.

When vetting both accounting professionals and legal accounting software, having a basic understanding of the key distinctions between general business accounting and legal accounting can be critical to making the right decision for your firm. In this two-part series, you’ll find some core tenets of legal accounting that pose unique challenges when it comes to bookkeeping and reporting.

CARET Legal invoices and payments

Invoice and payment management in CARET Legal

Cash vs. Accrual Basis

According to the American Bar Association (ABA) recommendation, law firms should perform cash basis accounting, which simply means income is recognized when money is received, and expenses are recognized only when paid. If you are not already filing on a cash basis, be sure to discuss this with an experienced accountant. There are tax ramifications involved in changing your reporting basis for the IRS.

Technology Tip: Often your accountant will want to see accounts receivable and accounts payable. Your billing and/or your accounting software should be able to provide that information for you. If not, the accountant will need to manually create a reversing journal entry at year’s end and January 1. Some software packages allow you to have a modified cash basis. These packages let you see accounts receivable and accounts payable, but they have no financial impact on the balance sheet. It’s best to find a platform that allows you to toggle from cash to accrual basis.

The Basics: Account Types

The account types do not change for law firms, but a brief understanding of them will make upcoming recommendations easier to understand.

All accounts appear either on a Balance Sheet or an Income Statement. Here is a simple way to look at things on a cash basis.

  • Balance Sheet Account Types
    Assets – You Own
    Liabilities – You Owe
    Equity – What’s Left
  • Income Statement Account Types
    Income – What money you collected
    Expenses – What money you paid

Balance sheets are not run for a period of time; they are “as of” a certain date. Income statements run for a date range. At the end of the fiscal year (usually the end of the calendar year), the net income or loss is written to the equity (capital section) of the balance sheet and the new year starts at zero. Remember the income statement zeroes out to understand costs advanced.

Costs Advanced

Let’s discuss costs advanced. This is one of the most significant areas in which law firms differ from other service firms. “Costs advanced” are also called “client costs,” representing your own money used to cover bills on behalf of your clients.

  • Hard Costs: payments made externally from an invoice or directly by credit card. They include things like filing fees, overnight delivery service, transcripts, photocopies when using an outside copy company or postage when a separate payment is made for the mailing.
  • Soft Costs: charges generally absorbed internally. They include postage through a postage meter, photocopy charges for documents photocopied internally, mileage reimbursement, and faxing.

Often, it can take months for you to get reimbursed for costs advanced. Most accountants expense your costs advanced immediately in the month of outlay. If this occurs, you are not matching the income to the expenses. Remember when we talked about the income statement and said that the accounts zero out? If you are not reimbursed in the same year, the income statement is closed. For this reason, hard costs advanced should be carried on the balance sheet as an asset to keep them on the books and off your income statement.

The IRS Attorney Audit Technique Guide addresses this issue. Hard costs are carried as assets and are considered loans by the IRS {Rule of IRC §111}. It states:

Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement. A bad debt deduction may be taken in the year that any costs are determined to be uncollectible.

However, attorneys on the cash method of accounting are generally allowed a current deduction for client-reimbursed costs which are allocated to normal operating expenses (for example, secretarial costs or copying costs). These are general office type expenses that would reasonably be incurred even if not charged to a particular client. Of course, if a current deduction is taken, any subsequent reimbursement from the client would be treated as income in the year of reimbursement under the tax benefit rule of IRC §111. Make sure your bookkeeper understands this.

Note: When you pay hard costs from the client trust funds, they are not considered costs advanced. Remember that costs advanced are only incurred when you advance your money.

In our next post, we’ll discuss trust accounting and the role of IOLTA and Escrow accounts in law firms.

Written by CARET Legal partner, Gerri Martin. Gerri is a Partner with Software Analysis Corporation and a member of Crosspointe Consulting Group, LLC. She holds her undergraduate degree in Accountancy and is a CPA. This gives Gerri the business background needed to understand the financial and management implications of implementing software and business processes.

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