At Kahuna Accounting, we serve hundreds of solo / small law firms and professional practice builders all across the country and have learned a lot about the challenges lawyers face on a day to day basis.
One of those challenges is trust accounting. It’s extremely important, as a small mistake can completely derail your career. It requires attention to detail and a lot of tedious tracking and documentation. And unfortunately, we’ve learned from experience, a lot of lawyers are mismanaging their trust accounts.
Our role is to help attorneys get a system in place to make it easy, but since we’ve seen so many mistakes, so much anxiety and so much unnecessary pain, we created this article to share the often overlooked and misunderstood basics of trust accounting and how you can create a system that makes it simple.
It’s time to get into a system that works and is easy to manage.
Why it Matters: Ethical Obligations
Most attorneys are well aware of the importance of managing trust accounting properly. The mistakes made related to trust accounting usually have more to do with honest mistakes and bad systems then malice. Nonetheless, an honest mistake could honestly end your practice, and that’s not a mistake any lawyer can afford to make.
Megan Zavieh is a state bar defense attorney and general ethics counselor, and this is what she says about how lawyers are playing with fire when it comes to trust accounting:
“The consequences for mistakes in trust accounting are severe. Ethics regulators tend to think attorneys have acted with moral turpitude rather than ignorance or confusion when a trust accounting violation occurs. Some states have standards that a trust account balance dropping below the amount that should be held for clients is deemed misappropriation. It is an uphill battle to show a lack of intent to misappropriate client funds, and the attorney’s defense is basically a showing that they lack skills and organization to manage their clients’ funds — not something most of us want to try to prove!”(Full article on Lawyerist here: https://lawyerist.com/66687/trust-accounting-basics/)
We’ll get into the details below, but this conversation about trust accounting is truly about you as an attorney handling someone else’s money. It’s not yours until you’ve earned it. So when you mismanage it, you are mishandling their money, which from an audit perspective can look like theft or fraud – even when it’s an honest mistake.
In most situations, mishandling this money is grounds for disbarment – even if it’s unintentional.
William Pfeiffer, a law practice management expert puts it bluntly:
“Properly managing a trust account can be a hassle, but losing a law license over sloppy record-keeping would be even worse.” (Full article here: http://law.about.com/od/financialmanagement/a/Lawyer-Trust-Account-Mistakes-3-Common-Lawyer-Trust-Account-Iolta-Mistakes.htm)
But that’s enough of the scary stuff. Odds are you know the importance of trust accounting and that’s why you’re here – to reduce this anxiety – which is why we’ve created this guide.
Trust Accounting Essentials
Before we talk about getting the perfect system in place, let’s review the essentials so that you can stay in ethical compliance even if you are operating within a broken system.
Here is a Quick Review of The Basics of Trust Accounting:
1. Keep Client Money and Your Firm’s Money Separate
You’ll need to have a trust accounting (or IOLTA) at your bank account. This account will hold all the money you receive from clients in trust.
No money should ever go into your firm’s operating account unless you can document work for earning that money.
2. Keep a separate client ledger for client money held in trust
You’ll need to use some type of system to track an individual ledger for each client who you have a trust account with. This can be done easily in practice management systems like Clio, but even if you’re starting with a spreadsheet, you need to have this ledger for each client.
3. Only transfer money to operating after it is earned
When you do the work for a client, you can then make a transfer to operating. Until you’ve done the work – this money is not yours. From an accounting perspective, you actually owe this money until you’ve earned it. Once it’s earned you can make the transfer to operating.
You can also use trust money to pay for client related costs while working on a matter and before you bill out for services.
4. Document movement of money and keep updated summary of client ledger
The client ledger needs to be continually updated as the money is earned. When you make a transfer, you now need to update the ledger to show what is remaining in trust and then you need to notify the client of where things stand. This is what you should be communicating to the client:
• Detail of work performed
• Total amount due
• Remaining client trust balance
Where does it go wrong?
Most attorneys will read these basics and understand exactly what’s required, and when you break it down the process is quite simple.
So where does it all go wrong? Why do we see so much mismanagement and frustration?
Here are some common mistakes and pitfalls:
1. You have a terrible system for tracking
Even when you mean well and understand it, if you are relying on data entry, spreadsheets and paper, there is a solid chance something will fall through the cracks.
A bad system is unhealthy for your entire firm in all areas of business, but can be extremely problematic in trust accounting.
2. Deposit in operating
Other credit cards will tie into your operating and so you’re already setting yourself up for failure by putting money that’s not yours into your operating account.
Make sure to deposit money right into the trust account.
3. Record in Clio but fail to transfer
In our experience, we see attorneys who are using Clio (so they have a working system) document a transfer in Clio, but forgetting to actually make the transfer. You then have inaccurate records in Clio and the money you are stating is transferred in Clio hasn’t actually occurred.
4. Make transfer but don’t record
Along the same lines, we’ll see attorneys transfer funds, but fail to document which creates inaccurate reporting. These are problems that just come down to forgetfulness and poor accountability. This emphasizes the need for a 3rd check (more on that later).
5. Mark the deposit as income
Finally, if you are using an accounting system, there could be a temptation to think money deposited in your Trust Account is an asset or income for the business.
As we discussed before, that’s not the case. These are not your funds and actually you owe the funds to your client until you earn them. So when you mark trust funds as income, you are overstating your firm’s financials, which can create problems at tax time.
Money in trust should be marked as a liability in your accounting system.
A System for Success – Example of a Workflow that Works with No Anxiety
The key to success in trust accounting truly comes down to three things:
1. Understanding and prioritizing the fundamentals
2. Leveraging and properly using technology
3. Having a third check on activity
We’ve already covered the fundamentals, but as we’ve stated, plenty of great lawyers who understand the fundamentals of trust accounting are letting things fall through the cracks.
Technology in itself is not the solution to this challenge, but can certainly help. The attorneys we work with often use Clio, which is a great practice management tool for managing client matters and ledgers.
They have built-in trust accounting and a way to track funds. Read more here: https://support.goclio.com/hc/en-us/articles/203878158-Trust-Account-Management-in-Clio
This is not meant to be an endorsement of Clio, but the takeaway is that you as an attorney need to have a system you are comfortable in that makes the client management side of this easy.
Another tool you’ll definitely want to have is LawPay, which allows you to accept funds directly into your trust account.
Now, let’s get into the accounting side.
Using an accounting system for reconciliation and a third-check
If, for example, you are using Clio for practice management, you may think you have everything you need for proper trust accounting, but in reality the solution is incomplete.
You need to have an accounting system in place to provide another check to see where the money is going and being tracked. At Kahuna, we use both QuickBooks Online and Xero cloud accounting software which integrates with Clio and the bank accounts so we can provide reporting on all financial activity.
This gives you three checks from different systems: 1. The client ledger, 2. The bank activity, 3. The accounting system
Every month you should be reviewing the three checks and everything should match!
Here is a quick example of a trust accounting workflow using Clio and Xero:
1. Receive Retainer Payment
- Deposit into trust account
- Add deposit in Clio trust account with consistent and accurate dates
- When funds hit trust account, Xero sees it happen at the bank
- Enter as pre-payment in Xero, so it’s not income, but it’s a liability (owed until it’s earned)
2. Billing Your Time
- Generate Bill in Clio for your work and now the bill is “awaiting payment.”
- Receive the payment in the operating account inside Clio
- Note: This marks the bill paid in Clio, but the funds haven’t actually moved
- Once you’ve created the bill in Clio, it will sync to Xero and show it’s awaiting payment
- This is why the accounting reconciliation is important, because if you don’t transfer the funds, Xero is going to show money missing that needs to be transferred
3. Reconciling the Transfer
- Open your original pre-payment invoice in Xero
- Click “Credit this invoice” to allocate credit for the invoice. This will reduce the amount in your pre-payment and display the transfer from trust to operating.
If you have an accounting system in place to watch the activity, you should never lose sleep again over trust accounting. You will always be able to match the client activity with the movement of cash.
To be extremely confident, you should do a three-way trust accounting check every month. This is what it looks like:
1. Review your trust account ledger
2. Compare the ledger report to the bank account totals
3. Compare both to the current liability account in accounting system
All three must match! Xero, the client ledger and the bank. If they don’t match, you have an error either in the transactions or the transfers.
If you find that a transfer didn’t get made, then you can make that transfer at the end of the month.
If an invoice or bill was not marked as paid, make the appropriate update.
To sum it all up, with the fundamentals in place and a third check for tracking, you’ll always have a second set of eyes on your trust account and should never have to worry about falling through the cracks.
We hope this guide provides you with everything you need to make sure you’re complying with trust accounting regulations and so you can get a couple of extra hours of sleep tonight. You need to have worries like trust accounting behind so you can focus on moving your business ahead. If you’re looking for a partner to manage your trust accounting and the bookkeeping for your practice, allow us to show you how we can benefit your firm. Fill out the short form on this page so we can get the conversation going, and your bookkeeping done right.
Schedule an appointment with our team and we can help you find the perfect solution for your law firm.