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This is the second installment in "The CPA Your Law Firm Needs". If you missed the first one, you can read it here: Law Firm Accounting and the CPA You Hire For It
The first item deals with Trust Accounting and IOLTA Compliance. Trust accounting isn't exclusive to law firms; it occurs in real estate and insurance industries as well. However, we're not talking about just holding funds here. We are talking about rules established by the State Bar that attorneys and law firms are required to follow.
Accounting mistakes can create tax problems. Trust accounting mistakes can create licensing problems.
That's why trust accounting and IOLTA compliance should be one of the first topics you discuss when evaluating a CPA for your law firm.
Many accountants work with professional service businesses. Far fewer have experience working with law firms. The difference becomes obvious the moment you start talking about trust accounts.
Trust accounting is not run like the rest of your books
I've reviewed law firm books where the operating account was perfect. Accounts were reconciled, expenses were categorized correctly, and the financial statements looked clean.
Then I looked at the trust account. The trust liability didn't match the bank balance. Individual client ledgers didn't tie to the liability account. Transfers between trust and operating were undocumented. Nobody had performed a proper three-way reconciliation in months, or ever.
Trust accounting requires a separate set of procedures that simply don't exist in most businesses. Your CPA should understand that client funds such as retainers are not revenue, are not assets of the firm, and cannot be treated like either.
What a CPA should be able to explain
When you ask a CPA about trust accounting, general statements about being careful or detail-oriented don't tell you anything. What tells you something is a process.
Someone who works with law firms can walk you through how trust balances are carried on the balance sheet, how individual client ledgers are kept current, how often reconciliations happen and who performs them, what documentation they expect behind a disbursement, and how they investigate a difference when one turns up. None of that requires preparation. For a CPA who does this work, those are routine conversations.
The three-way reconciliation
One of my favorite questions to ask is simple: "How do you perform a three-way trust reconciliation?"
The answer should be immediate. At any point in time, three numbers should match:
- The trust account bank balance
- The trust liability account on the books
- The total of all client trust ledgers
If those three numbers do not agree, something needs to be reviewed. The mismatch could be an uncleared transaction. It could be a posting error. It could be a transfer that was recorded incorrectly. The cause is often minor but leaving it unidentified is the part that creates the problem.
Negative client balances
A negative client ledger is one of the first things I look for, and it's the fastest way to tell if anyone has been watching the trust account.
A negative balance means more went out for that client than the client had on deposit. Sometimes a fee was withdrawn before it was earned. Sometimes a disbursement went against the wrong matter, or a transaction was posted to the wrong client. Most of the time the cause is a data entry error, and most of the time it's fixable quickly.
What it means while it sits there is that one client's funds are covering another client's activity. A CPA who works with law firms will have a procedure built specifically to surface these, because they know the balance itself is only the symptom.
Technology Alone Won't Solve the Problem
Many practice management and legal accounting platforms include trust accounting functionality. That helps, and it isn't enough on its own.
Software can automate reconciliations, but it cannot determine whether transactions were entered correctly. It cannot identify a poor workflow. It cannot establish internal controls. I've seen firms with excellent software and terrible trust accounting. The software supports the process; it doesn't replace it.
Questions to ask, and what you're listening for
How many law firms do you work with now? You're after a current number. Trust rules vary by state and get updated, and someone who worked with firms years ago may be describing requirements that have since changed.
What's your process for monthly three-way reconciliations? The answer should arrive without hesitation, an answer that stays at the level of "we reconcile monthly" hasn't told you anything yet.
How do you investigate a trust discrepancy? Listen for where they'd look first and in what order.
How would you handle a negative client trust balance? What you want is a same-month correction and a look at what produced it.
What trust accounting errors do you see most? Anyone who works with law firms has a ready answer here, usually a specific one.
Before You Sign With Anyone
Accounting errors can be corrected. An amended return, an adjusting entry, a conversation with the IRS. Trust accounting mistakes carry ethical and regulatory consequences that reach your license, which is a different category of problem.
That's why your CPA should be able to describe their process in detail. If the answer sounds vague, theoretical, or entirely dependent on the software, keep asking questions. This is one area where somebody's process tells you more than their credentials will.
Talk to me about your firm. I work with law firms and professional service practices, and I usually start with the trust account. If any of this sounds like your books, book a meeting and we'll take a look together.
Next in this series: how hourly, flat fee and contingency work behave differently once they're in your books.
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