Law Firm Accounting: It Is Not the Same!!! (Part 2)

Last week, we explored several key elements of legal accounting that differ from general small business accounting, looking at cash basis vs. accrual, account types and costs advanced. In this article, we’ll explore trust accounting which is arguably the most intricate, and ultimately error-prone, component of legal accounting.

Trust Accounting

Trust money is money you are holding that does not belong to you. You cannot commingle this money with your regular operating bank account even if you keep a separate ledger for it. To keep funds separate, you need to set up a separate bank account for trust funds. There are two types of trust accounts: IOLTA and Escrow. Not all banks are created equal when it comes to trust accounts. Be sure your bank can handle the accounting properly. Click here to find a directory of IOLTA programs by state to check out specific requirements.

IOLTA Accounts

“IOLTA” stands for Interest on Lawyer Trust Accounts. An IOLTA account is for the deposit of client funds. It pays all interest earned to the Lawyers Trust Fund. Interest generated on IOLTA accounts is an important source of funding for civil legal aid.

IOLTA programs have taken a leading role in funding innovative programs that have had a positive impact on the delivery of legal services to the poor. These include loan repayment assistance programs, state-based legal information Web sites and legal assistance hotlines. IOLTA programs also fund a variety of other activities including: alternative dispute resolution programs, young lawyer special public service projects, victim services programs, court-appointed special advocate (CASA) programs, pro se assistance resources, minority lawyer recruitment initiatives, and law school scholarship programs.

There are many rules around IOLTA accounts and associated transactions. An accountant with legal accounting experience can help to ensure all requirements are met. Consider the following:

• No charges not directly attributable to a matter can be made from the IOLTA account.
• Credit card fees should be charged against your operating account and the client’s trust deposit is credited in full in the trust bank account. Make sure your credit card processor can handle this.
• Bank charges like wire transfer fees and stop payments need to be reimbursed by you immediately should these charges occur in your trust account.

Escrow Accounts

Escrow Accounts are interest bearing accounts. Generally, the money in these accounts is not exclusively for you. They are for funds to be disbursed to other parties — for example, the receipt of funds for the sale of property to be disbursed to your client, the mortgage company and yourself for fees. These interest-bearing trust accounts require that the client receive the interest. You cannot take the interest on this type of account.

Under ABA Rule 1.15(g), lawyers should exercise reasonable judgment in determining whether client funds should be deposited into an IOLTA account or a separate client trust account. Lawyers should consider three factors in making this decision:

• The amount of interest the funds would earn during the time they are likely to be held
• The cost of establishing and administering a separate account
• The capability of the financial institution to pay net interest to individual clients through the use of sub-accounts

Remaining in Compliance with Legal Accounting Software

There are certain things to keep in mind when it comes to trust accounting, such as the need to track client ledgers individually while keeping all trust funds pooled in one bank trust account.

Legal-specific accounting software helps safeguard against common mistakes, including:

• Overdrawing the client ledger. Some legal accounting applications prohibit users from generating a trust check for more than the amount in Trust for that Matter.
• Three-way trust reconciliation. All three numbers must match on the trust balance, the trust liability on the balance sheet, and the Client trust ledgers. CARET Legal has a report specifically for this purpose.
• Tracking and timing of payment from Trust to Operating when earned. You cannot take your money from the trust account until it is earned and your client has had sufficient time to review the charges. Never issue a refund of retainer until you are sure the funds have cleared the bank (usually 10 days).
• Check stub requirements and confidentiality. Attorneys have the legal obligation to keep matter-related information confidential; this applies to check stubs.

As a matter of course, firms should take the following measures:

• Use different check colors so an Operating check is easily distinguished from a Trust check. When possible, put the check and stubs in different places so an Operating check can never be printed on a Trust check.
• Matter and client number can show on check stubs, but not names on stubs going outside the firm.
• When using client funds to pay a vendor, the stub must contain a detailed description, or a detailed report attached for your client’s review.
• Allocation of partial payments. When a client does not pay you in full, the allocation of the money is distributed in the following manner until used up:
  • Taxes (100%)
  • Costs (100% or until used up)
  • Fees (generally allocated to timekeepers by pro rata share)

As you can see, there are many differences and considerations when it comes to law firm accounting. It is your professional responsibility to educate yourself and leverage accountant expertise with legal-industry experience when necessary. Specialized legal-specific accounting programs can also help to ensure compliance.

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.