Why Do Law Firms Need Trust Accounting?

Working in a law firm is very different than working as a doctor or accountant. You represent your client and handle your client’s money, the money in dispute, and the money received in a case settlement. You even pay the court fees on behalf of your client. Handling others’ money requires additional compliance and care, transparency in accounting, and detailed record-keeping to avoid misunderstandings. That calls for a trust account and trust accounting. An accountant specializing in legal practice understands the nuances of trust accounting and can help you set up an accounting and bookkeeping system. This article will tell you about the nitty-gritty of Trust accounting. Without much further ado, let’s begin with the basics.

What is a Trust Account in a Law Firm?

A law firm maintains an operating bank account where it accepts legal fees, pays business expenses and paralegal salaries, and conducts all business transactions related to the law firm. The firm also opens and manages a client trust account, a bank account in the law firm’s name and under the law firm’s management. However, the money deposited in that account belongs to the client.

A client may give you a check, bank transfer, or cash to keep as a retainer fee or as an advance to pay court fees and other expenses involved in their case. Sometimes, you may receive settlement money on behalf of the client or may have to keep disputed money with you until the case is resolved. All this money will go into the client trust account, as it is not the money you have earned.

Do not confuse a client trust account with an escrow account. The latter is managed by a neutral third party and holds funds or assets for you during transactions, like real estate deals. The former is managed by your law firm to fund legal services.

The golden rule of a trust account is to keep business, personal, and client transactions separate. And the best way to do so is to have a separate bank account for each. If you co-mingle funds, there could be some serious ethical and legal repercussions.

Types of Client Trust Accounts

When you create a client trust account, you have two options:

• Pool trust account: All clients’ money is deposited in just one account. This may work if the funds are small. Such an account requires meticulous accounting and reconciliation, as there is a risk of mixing different clients’ funds.
• Separate trust account: If a client is large and the funds are substantial, it is better to have a separate account for that client.

For instance, a law firm dealing in real estate properties may use a separate account for each client. However, a law firm handling criminal cases may maintain a pooled account.

Once you have created a trust account, it is time to set up the accounting system and establish ground rules for managing it.

Setting Up and Managing a Trust Accounting System

1. Depositing funds: The client gives the law firm funds, which the firm deposits into a dedicated trust account. If it’s a pooled account, several lawyers at the law firm will have the right to deposit funds into the trust account.

To ensure the staff does not improperly deposit or withdraw money from the Trust account, you can set up an approval system. For instance, only approved transactions from senior lawyers may be allowed.

2. Withdrawing funds: This is a tricky part. Now, the client’s trust account may contain retainers, which are the unearned funds. You may think that it will become your income in the future, and you may be tempted to withdraw or borrow money if your firm is facing a cash flow crunch. However, it violates trust accounting rules and can jeopardize your professional integrity.

Remember, trust accounting is all about complying with the rules to avoid issues. You cannot misuse client funds to pay operating expenses of the law firm or to buy something for personal use.

You can use the funds to get paid for the completed work or to cover the client’s legal expenses, such as court fees. You can withdraw money in two ways:

• Pay client expenses from the client trust account and write a withdrawal entry in the trust ledger and a paid entry in the client ledger.
• Pay client expenses from the law firm’s operating account and bill the client the legal fees and expenses on the monthly or bi-monthly invoice. This requires no entry in the trust ledger and a normal entry in the client ledger.

3. Recordkeeping: You will have to keep proper records and documents of each transaction:

• The signed compensation agreement between you and the client details how you will charge the client and who will bear the expenses.
• All records of electronic and physical transfers from bank statements to deposit records, pre-numbered cancelled checks, substitute checks from the financial institution, and chequebook registers. You can get these documents from the financial institution where you opened the trust account.
• Next, you need documentary proof of disbursements to third parties, such as third-party accounting records, invoices, and receipts.

4. Reconciliation: Along with these records, you have to write down the transaction details in the

• Trust account ledger: Date and amount of deposits and withdrawals, source of funds, purpose, description of each transaction, and the payee who collected the withdrawal.
• Client account ledger: Client’s name, amount of deposits and disbursements, description of transactions, sources of deposits, and names of the people or entities who received disbursements from the client’s funds.

Now, you have to reconcile the two ledgers with the bank statements to ensure all three are in sync and that no transactions are missed or incorrectly reported.

5. Settle client accounts: Once the case is closed, you have to do the final calculation, deducting expenses, fees, and any other costs discussed with the client, and transfer the remaining balance to the client account. The transactions should be recorded in the two ledgers listed above.

This entire Trust accounting system requires meticulous bookkeeping, accurate tracking, and three-way reconciliations to prevent the misuse of funds, which in turn requires specialized accounting.

Contact KSSP Partners LLP in Markham to Help You with Trust Accounting Needs

A professional accountant specializing in legal practices can help you set up a trust accounting system, prepare ledgers, do reconciliation, and perform timely audits to ensure the client’s funds are used properly. To learn more about how KSSP Partners LLP can provide you with the best cloud accounting and bookkeeping services, contact us online or by telephone at 289-554-5997.