Transactions have a stronger impact when they are communicated at regular intervals to all facets of the company. Just as transportation carriers operate on a regular schedule to optimize resources, effective planning requires regular communication to maximize opportunities. This holds true in law firms just as much as it does anywhere else. In this guide, we will explore how small law firms communicate their financial status and adapt accordingly for better results both short term and long term.

Successful accounting starts with successful bookkeeping, which includes the proper accounting methods implemented in law firms. We’ll introduce best practices for keeping track of financial transactions and make sure you know what you should be doing every quarter and year. Finally, we’ll discuss the importance of financial planning and financial reports.

Bookkeeping overview for law firms

A law firm’s bookkeeper is responsible for organizing all transactions from beginning to end. This means recording every transaction at the time it occurs and keeping track of the money that flows into and out of a firm. The bookkeeper’s primary goal is to ensure all financial transactions are accurately recorded in order for higher-level employees to make accurate financial decisions.

The primary task of the attorney bookkeeper is taking charge of the record-keeping responsibilities. These records are used by firm management for various purposes, including billing clients and monitoring profitability. The attorney bookkeeper should keep abreast of new legislation that may affect their law practice and be able to apply these changes throughout their accounting system.

The bookkeeper must consistently monitor the flow of money into and out of the firm. This requires the use of software that tracks incoming bills, payments received by clients, payroll disbursements, and any other type of purchase or sale. The attorney bookkeeper’s duty is to make sure all transactions are accurately recorded in order for higher-level employees to make accurate decisions regarding their practice. Particular attention should be paid to ensure the accuracy of recording billable time spent on each case as well as ensuring proper collection on accounts receivable/debt collection efforts.

Most common accounting and bookkeeping mistakes for law firms

You should be wary of firms that only pursue the cheapest solution. While it is important to save money, your bookkeeping and accounting systems are not created equal. Making mistakes in these areas can cost you a great deal of time, money, and effort later on down the road. The following section details some common errors that can happen when dealing with a firm without experience in legal accounting:

Bookkeeping mistakes

  • Choosing a software system that does not have all the features you need
  • Using inconsistent or incorrect abbreviations for accounts
  • Entering transactions using an antiquated methodology (e.g., cash basis instead of accrual)
Accounting mistakes
  • Incorrectly setting up your chart of accounts, which is essentially the list from which your reports are drawn
  • Lacking an understanding of which reports you need and how to read them
  • Creating a false sense of financial security by not thinking about the future and ignoring changes in the law.

​​Legal accounting terms you need to know

GAAP = Generally Accepted Accounting Principles, the rules that govern how financial institutions report their information; also known as International Financial Reporting Standards (IFRS). We’ll go into more detail later on these.

Accrual Method = rather than taking cash as income when it comes in, you accrue revenue as soon as a transaction is completed. This means that your cash flow includes all revenue, not just the money you have received in the bank.

Cash Basis Method = when cash comes in or out of your business it goes directly into or out of the account, rather than being tracked over time.

Chart of Accounts = a list of accounts (categories) used to keep track of your business’ finances, usually through an accounting software system; also known as the general ledger. The chart of accounts is typically divided into two sections: current accounts and non-current accounts. Current accounts are for items you will use up within one year (e.g., supplies, payroll), while non-current accounts are for anything that you will utilize longer than one year (e.g., real estate, furniture).

Non-Current Liabilities = anything you owe over one year, typically debts or bills that must be paid off within three years (e.g., mortgages).

Double-Entry Accounting = a system for keeping track of your business’ finances in which each transaction has two corresponding accounts (categories), one where the money comes from and one where it goes to. It’s also known as a double-entry bookkeeping system, this is an accounting method that requires details about transactions to be entered twice; once on the debit side of an account and once on the credit side, ensuring that no transaction is completed without at least two corresponding entries.

Interest on Lawyers Trust Accounts (IOLTA) = a special bank account for lawyers to hold their client’s money in. This is a type of trust account created by the courts for attorneys to deposit settlement funds, advance fees, and other miscellaneous payments made on behalf of clients. These accounts are protected by federal law from being attached or foreclosed upon.

PEGGED = when items such as depreciation and/or amortization can only go down over time (i.e., the opposite of indexed ). This means they’re pegged at a specific rate each year despite inflation—and therefore never reflect actual changes in the cost of doing business.

General Ledger = another name for your chart of accounts; also known as a chart of accounts. It is typically divided into two sections: current accounts and non-current accounts. Current accounts are for items you will use up within one year (e.g., supplies, payroll), while non-current accounts are for anything that you will utilize longer than one year (e.g., real estate, furniture).

Why hiring a CPA matters for law firms

Attorneys often find themselves in the challenging position of handling their own bookkeeping needs when they become sole practitioners or open smaller firms. While this is usually manageable when you’re starting out, it can become a far more difficult and time-consuming process as your practice grows.

After all, the average lawyer spends about 80 percent of their workday using some form of technology to handle client-related tasks such as research and writing, leaving only about 20 percent to deal with actual client matters, and most of the time is spent explaining and documenting financial transactions related to clients.

This means that even if you have basic bookkeeping skills, there’s simply not enough time in each day for you to properly manage the financial health of your firm.

Whether you’re a sole practitioner or part of a larger law firm, it’s generally a good idea to hire a professional CPA for your accounting and bookkeeping. A CPA will bring added benefits beyond just knowing how to keep your books.

A lot of CPAs are also attorneys, so you’ll be able to get legal and tax advice from the same person. This can save time and money compared with hiring different professionals for each type of service, as it helps avoid potential miscommunications if you have to explain things more than once or work with someone who doesn’t understand why certain information is relevant.

Best accounting practices for long-term finances

Open a business bank account

Whether you’re setting up your business as a corporation, partnership, LLC, or sole proprietorship, opening a separate business bank account will benefit you by keeping your business’ finances separate from personal ones. This will help minimize the chance of making mistakes that can cost you time and money or lead to penalties down the line.

If your law firm is part of a larger company—either a larger law firm or an in-house legal department— it’s generally best practice for this entity to open the business bank accounts rather than individuals in that organization. This helps avoid potential conflicts of interest and protects the organization’s personal finances from being put in jeopardy if a business transaction goes astray.

Determine an accounting method

Cash accounting

Cash accounting is the easiest method to use when it comes to bookkeeping, but it’s also considered the least accurate from a tax planning perspective.

This means that when you’re using cash accounting, you only count revenue or expenses in your books when you actually receive or pay out money—this can help cut down on discrepancies and make taxes easier since there won’t be any need to reconcile things later on.

However, this method doesn’t take into account how much money is coming in and going out over a certain period of time; rather, it just looks at figures for an individual transaction.

Accrual accounting

If you use accrual accounting, on the other hand, you’ll count income or expenses when they are earned or incurred regardless of whether or not payment has been received. You still won’t make any assumptions about how much money is coming in and going out over a certain period of time since this will be calculated at the end of your fiscal year.

This method is more accurate for preparing financial statements because it helps to calculate revenue and expenses based on estimates that may have changed before everything is actually paid off. However, it can be more difficult to keep track of all your transactions when it comes to taxes.

Cash vs accrual accounting: which method is best

Generally speaking, most larger law firms that deal with debt collection will need to use accrual accounting in order to accurately report their figures; however, those who primarily focus on providing onetime services such as writing wills might be better off with a cash accounting method.

One important consideration is that you’ll need to use the same accounting method from one year to the next. Accrual accounting results in a higher tax bill during the fiscal year since income will be taxed as it’s earned. Most businesses can delay paying taxes for up to 12 months using cash accounting; however, you may also face penalties if you fail to make estimated tax payments throughout the year.

You can decide which method works best by considering each one’s benefits and drawbacks such as how much time they take to set up vs their cost, your existing business practices, any changes in your company’s situation, and future plans.

Keep financial records

Regardless of which accounting method you use, you should keep all your financial records and documents safe for seven full years. This includes:
  • Your books and records including checks and bank statements;
  • Financial and business plans and forecasts;
  • Employment tax records including W-2s and 1099s from any contractors or freelancers you’ve hired;
  • Copies of all contracts with clients or other companies that might have an impact on your business expenses;
  • Copies of all receipts you received for any business-related purchases or services;
  • Copies of any reports or statements that were filed with the state, federal, local government, or professional organizations;
  • Copies of all tax returns that have been filed for your business, as well as receipts for any expenditures you deducted on those statements;
  • Copies of any applications or documents you submitted to the IRS, and Any documents related to your company’s assets like leases, rental agreements, insurance policies, etc.
  • This may seem like a lot of extra work, but you’ll be glad you decided to keep these records later on if your business is audited that requires you to prove what happened.

Types of assets have a big impact on a law firm’s financial practices.

Depreciation – The loss in value that an asset experiences over time because it was used. The two types of depreciation are expensing and straight-line. They both depend on how much the asset costs, its lifespan, and whether or not it’s being used.

Capitalization – This is when an expense incurred by your company is added to the cost for an asset so it affects the depreciation rate, which determines how fast the asset is depreciated. When you capitalize an expense, it’s treated as an immediate reduction in the amount of money that was spent on acquiring the item or service, so it will affect your income statements and balance sheets.

Monitor cash flow and capital expenditures

Your cash on hand is probably one of the most important factors in any business. You don’t want it to run out, but you also can’t let it sit around for too long or else you might miss out on opportunities that come your way. A good rule of thumb is to monitor how much money your business actually has at all times, and plan accordingly based on where it’s going and where you expect it to be later down the line.

You also need to understand and track capital expenditures, which is the purchase of any item or equipment that will help you expand your business. The money used for these purchases will be reflected on your balance sheet as an asset, and they’ll affect your income statement because it needs to be capitalized (meaning that its depreciation cost must be included) if they’re expected to last more than one year.

You should only make a capital expenditure if the new equipment or property you’re getting allows you to generate more revenue than before, but keep in mind that not all expenses fall under this category; some may need to be expensed immediately instead.

Build cash reserve and credit lines

Cash is usually the biggest constraint on business growth, and it’s often difficult to find enough money to meet your needs. The trick is to build a cash reserve while still allowing some extra spending for capital expenditures and expansion.

You can do this by creating a cash reserve or a cash reverse line of credit. The first option is a good choice for businesses that have more constraints on their spending, and it allows you to set aside a certain amount of money every year so there’s always some available. This works well if your company only has one or two major expenses per year, but it doesn’t work as well if you spend the same amount all at once because the money won’t be available until the next fiscal year. In this case, a credit line is normally better because it gives you immediate access to funds when needed.

How to succeed at accounting and financial planning

Set a budget

Most businesses need to set a budget so they can already have an idea of how much money they’ll be able to spend in the next fiscal year. A budget is a detailed outline of expected revenue and expenses, which can help you predict whether or not your business will have enough money to pay for these expenses.

This is especially important for law firms because they never know when they’ll get a new case, and it’s difficult to plan out. Law firms may need annual or even monthly budgets that outline their current financial situation and give them an idea of how much they can spend on new opportunities.

The trick here is to set a budget that realistically accounts for your current financial status, but also allows you some room to change it if something unexpected comes at you. You can use your budgets to create different plans depending on how much money you have, and you should always keep them up-to-date so they reflect any changes in your company’s priorities or financial health.

Financial reports

The best way to manage your finances and keep up with your growth is by putting together regular financial reports. The first type should be a monthly report that breaks down how much money you’ve made, so you know where you stand before it’s time to pay the bills. A quarterly report will give you an idea of how things are going as you move forward into different seasons or phases of business growth, and an annual statement summarizes all of this information for tax purposes.

Income statement

Your income statement is a record of your company’s earnings over the course of one year, and it starts at zero every January 1st to account for the previous twelve months. All money earned should be recorded here, whether it comes from customer invoices or other sources like loans or grants, but expenses are only accounted for if they’re directly related to revenue generation.

The income statement report can also include information about your total gross profits, which is the amount of money you made after all business-related costs have been deducted. The main figures that should remain in this report are your net profits, which is the amount of money you actually keep after taking into consideration how much tax you’ll have to pay on this figure.

Balance sheet

A balance sheet is a record of your company’s assets and liabilities, which outlines the difference between how much you’re worth and how much money you owe. You can find a more detailed explanation here, but in general terms, an asset has a value that may be used to generate income at some point in the future, while a liability will result in immediate costs for your business.

Statement of cash flow

The cash flow statement is different from the income or balance sheet in that it doesn’t outline how much money you’re bringing in overtime. Instead, this report explains how cash is moving through your company on any given day, and what might be causing major changes to your business’s financial health.

At the top of the report, you’ll see your beginning cash balances, followed by data on when you received or paid money, including cash purchases and other expenditures.

While the above are the main categories for your report, there are many more to choose from in order to get a better idea of where your money is going. Some examples include changes in accounts receivable, how much cash your company generates, changes in short-term investments, and so forth.

Forecasted cash flow

Since the cash flow statement is an ideal way to monitor your business’s income and expenses on a daily basis, you can use this report to create a projected budget for yourself. This forecasting process involves projecting how much money your business might take in or spend over a certain time period, like a month or year, and can help you make better choices about your financial health and how it might affect the future of your company.

Statement of retained earnings

A statement of retained earnings sums up how much money your company brings in during a certain period, and adjusts it to account for any dividends or other payments that you’ve decided to reinvest back into the business.

One reason why this report might be useful is that it can help you see what percentage of your net profits are going toward operational costs at a certain point. This sort of information can come in useful when you have to consider what percentage of your money should be going toward business growth, which is a major part of creating a long-term plan for your company as a whole.

KPI

A key performance indicator, or KPI for short, is a measurable statistic that helps you work towards certain goals. You can think of this figure as a way to gauge how well your business is performing over time while keeping track of important figures like revenue and expenses, and it’s often customized to meet the specific needs of any business.

This report may be more useful to you if you have a small business and want to keep on top of how your company is doing on a regular basis without having to spend too much time tracking down data. Unless you’re in an industry with strict regulations, there’s no clear-cut list for what information should go into this standard report, but it’s a good idea to find out what your KPIs are and what you’ll need to do in order to keep track of them.

At the very least, businesses should be looking at one month worth of data at a time.

Financial security for your law firm

Insurance

Insurance is another major aspect of financial planning that attorneys should take into consideration. Many types of policies are available for lawyers, including malpractice insurance, which can help protect your business from negligence claims brought against you by clients.

There are many different options to choose from when it comes to legal protections, but the best place to start is simply understanding what type of insurance you need. For instance, if you’re starting a new firm from the ground up or shifting one that you’ve already set up, business continuation insurance can provide financial security should anything happen to your office.

Taxes

You can’t talk about financial planning for attorneys without bringing up taxes, including the different types of fees that you might need to worry about when it comes to running your business.

There’s no clear-cut tax rate for attorneys, and even the same individual might see different rates depending on what type of work they do. For instance, lawyers who focus on family law often get taxed at a lower rate than those who handle more technical matters like patents and trademarks. Generally speaking, it’s a good idea to speak with an accountant to see what kind of fees you can expect to pay as a small-business owner.

Tax planning is another important part of your financial plan as an attorney and can help you keep track of expenses that might be tax-deductible as well as those that will need to go toward future obligations like receipts and purchase records.

Choose an accountant for your law firms

An important part of setting up a business plan is choosing the right professionals to work with as you go about setting up your strategy.

When it comes to choosing an accountant for your law firm, look at what you need the most help with and how much data accuracy matters to your business. Even if you choose a professional who charges lower fees than their competitors, there’s no point in hiring someone whose services don’t quite meet your needs.

Finding an attorney who can help provide tax planning and compliance might be a better idea for some businesses, while others might need legal protection or professional liability insurance to keep on top of financial matters. It’s essential to find a team of professionals with a wide variety of expertise to meet all your company’s financial goals.

At Envolta, we offer a number of services that can help you keep track of your law firm’s financial health, including bookkeeping and back-office support as well as legal matters. We can provide better insight into your financial situation, allowing you to focus on areas where you’re providing the most value for your clients.
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