Most lawyers are not looking forward to the tedious process of reconciling their trust accounts, but every law firm that has a trust account must do it. I must admit, trust accounting can be challenging. That’s why our goal in this article is to give you some practical tips to help you better understand the process and make it less challenging.
Before we discuss some of these tips and best practices, let’s address the two opposite approaches that many law firms take to trust accounting.
Contrary to popular myth, ostriches do not bury their heads in the sand when frightened. Instead, they either run away or flop to the ground and try to blend in with their surroundings. In other words, the ostrich is not likely to deal with a challenge or the potential challenge directly. This is one extreme of the law firm approaches: avoiding the challenge of proper trust accounting and just hoping the firm stays under the radar and is never noticed by the bar association.
On the flip side, crows are known for their remarkable intelligence and their ability to approach challenges with curiosity and resourcefulness. These birds have been observed using tools, solving complex puzzles and even planning for future needs. Here lies the other extreme approach when it comes to law firms: a methodical, well-executed plan to deal with the challenges of trust accounting.
Your firm has an obligation to provide proper safekeeping practices when it is in possession of property belonging to clients or third parties (see Model Rule of Professional Conduct 1.15). Additionally, each state may have specific rules that vary from others, so you should review the regulations in your state.
To fulfill your obligation, an "ostrich approach" to trust accounting should be completely rejected. However, if you are still considering this approach, here is a list of potential consequences that could result from not complying with the rules around trust accounting.
Now that we understand the seriousness of the consequences, let’s look at some processes and tips that you should, and in most cases must implement.
Most states require that you establish a separate bank account for your trust account with a financial institution that is participating in the state’s IOLTA/trust program (most states have a list of participating banks).
When your firm has very few account transactions, you might be able to track this manually on a spreadsheet or some form of a ledger. If the firm has outgrown a simple spreadsheet, then you should consider either legal-specific trust accounting software programs or practice management software that includes trust accounting. Remember, not all platforms that advertise trust accounting comply with the requirements of your state bar. Be sure that you do some due diligence.
Ensure deposits and payments are properly recorded by establishing procedures and conducting periodic process reviews.
To do these routine process reviews, the firm can pick one client and walk through a couple of their transactions to ensure that client payments and all legal work performed have been properly recorded in the client’s case. If any errors are found, work with your team to understand why and address the root cause of the issue. (Please note that this does not replace the required monthly trust account reconciliation described below.)
Based on my experience of running an accounting firm that specializes in accounting for law firms, the two biggest errors are usually either that deposits into the trust account are not being properly identified to the correct clients or that the firm is using funds from the trust account to pay for operating expenses.
Your routine reviews and the bookkeeping process should catch both types of issues.
Ensure payment processing fees are not deducted from your trust account.
When your firm accepts electronic payments from clients, the credit card, bank or payment processors (LawPay, Clio Payment, Stripe, PayPal, Amex, etc.) will likely charge you a fee. This fee is generally an operating expense for the firm, so the payment processor should bill these fees separately against your operating bank account. Sometimes this may not be possible, and Model Rule 1.15(b) authorizes lawyers to keep some of their funds in the trust account to pay processing charges, but you must account for them.
Fees may only be about 3 to 5 percent, but when you think about all of your client transactions, these add up quickly and cause significant deficits in your trust account if this is not set up properly.
Another area to watch is charge-backs (credit card refunds). In some situations, a firm may have transferred earned trust funds into its operating account, but afterward, a client initiates a credit card charge-back. In this case, the firm should have a process to ensure that the charge-back is removed from an operating account, but not the trust fund account.
There may be some very specific exceptions, depending on the situation you may be dealing with, but this is a general rule that can protect your firm.
The specifics of performing a three-way trust reconciliation may vary from state to state, so use this approach as a general guideline, but you should also review your state's specific rules.
A three-way reconciliation is a simple process, but some significant, detailed steps need to happen for it to work properly. This is where working with a competent accounting firm/bookkeeper who understands law firm accounting and can confirm their reconciliation process is critical. Keep in mind that even if you are working with an accounting firm or bookkeeper, the state bar and the clients will hold your firm responsible for errors and issues.
Here’s an example of a simple breakdown of how a three-way trust reconciliation process typically goes:
Typically, this three-way trust reconciliation is performed by your accountant/bookkeeper, so make sure they have a process in place for this. Not all accountants/bookkeepers understand how to complete these steps, so please ask your accountant/bookkeeper for proof of their process. Many firms have found out the hard way that their accountant/bookkeeper misrepresented their skills and unfortunately had serious issues when it was time to clean it all up. Even if an accountant/bookkeeper performs this task for you, you may not delegate your responsibilities to them, so be sure you review the reconciliation to be certain it has been performed and performed correctly. The buck stops with you.
If you follow the "crow approach" to trust accounting—a methodical, well-thought-out plan that incorporates the above tips—reconciling your trust accounts should never be a source of dread.
If you need additional assistance or guidance with trust accounting for your firm, consider these final tips:
