General Accounting Procedures and Practices

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General Accounting Procedures

Introduction

Accounting is the method used to convey information regarding a law firm’s business activities. What the law firm owns, what the firm owes and how the firm performs are measured by accounting. Accounting is used to measure the amount of money available to distribute to partners. Accounting is used to communicate information to a law firm’s management, partners and creditors.

Law firm financial statements are constantly changing. The financial statements are management’s way of showing the firm’s position at a single point in time or over a set period.

This section includes the following topics:

  • Generally Accepted Accounting Principles (GAAP)
  • Financial Statements

Generally Accepted Accounting Principles (GAAP)

The power to set accounting principles rests with the Securities and Exchange Commission (SEC) in the United States. The body with primary control is the Financial Accounting Standards Board (FASB). Pronouncements issued by the FASB are presented in detail, and new rules are constantly being developed to address the continued globalization of business. Law firms with offices in multiple countries face multiple, and sometimes conflicting, sets of rules regarding their accounting.

Generally Accepted Accounting Principles (GAAP) are the rules and standards used by accountants to prepare financial statements in the United States. GAAP traditionally employs the accrual accounting method to determine the impact or treatment of a financial transaction. The rules also specify what needs to be disclosed.

Law firms do not generally follow GAAP when preparing financial statements. Most law firms operate on a cash or modified cash basis. These methods are simpler to use and follow more closely the tax-based statements.

Accrual basis accounting recognizes revenue when earned and expenses when incurred. Law firms in general do not use accrual basis accounting due to the large amount of accounts receivable that would be treated as received when billed.

Cash basis accounting recognizes revenue when the cash is received and recognizes expenses when the cash is paid. Modified cash basis accounting includes the cash basis accounting principles and some aspects of the accrual basis.

The modified cash basis is the method used by most law firms. This applies whether the law firm is a corporation or some form of partnership. The modified cash basis of financial reporting is preferred to a straight cash basis because it does not distort the firm’s operating results when reporting over longer periods of time. The modified cash basis involves logical and consistent modifications to transactions or events that occur from cash receipts or disbursements.

Modifications to the cash basis commonly include the capitalization and depreciation of property and equipment, recognition of receivables from client disbursements, accrual of retirement plan contributions payable and the recording of loans payable. Law firms can and do adopt different modifications to the cash basis of accounting.

A law firm’s accounting records provide most of the information needed to prepare the firm’s financial statements. The ability to read and understand financial statements is critical to a law firm manager’s success.

As a law firm manager, you are responsible for analyzing the firm’s financial condition, preparing and reconciling budgets, preparing and managing cash flow schedules and estimating profitability. You need to understand how to manage financial assets. You need to understand how your firm’s entity type impacts the form and content of your financial statements.

While many equations or ratios are used in accounting and financial management, there are three that everyone in law firm management should understand. These equations are the basis of most financial reporting.

Net

Assets

Equation

Revenues

and

Expenses

Equation

Cash

Flows

Equation

ASSETS REVENUE CASH FLOWS FROM
minus minus OPERATING ACTIVITIES
LIABILITIES EXPENSES plus
= NET ASSETS =NET INCOME CASH FLOWS FROM
INVESTING ACTIVITIES
plus
CASH FLOWS FROM
FINANCING ACTIVITIES
= NET INCREASE
or
DECREASE IN CASH AND
CASH EQUIVALENTS

Financial Statements

The four basic types of financial statements are:

  • Statement of Net Assets (Balance Sheet)
  • Statement of Revenues and Expenses (Income Statement)
  • Cash Flow Statement
  • Changes in Owners’ Equity (Retained Earnings) Statement

While every law firm has variations in its reporting, every firm should include “notes to the financial statements” which immediately follow the basic statements. These notes allow you to report and explain what cannot easily be included in the body of the statements.

Notes to financial statements could include a description of the firm’s operations, specific accounting policies, billed disbursements, fixed assets, lease commitments, commitments to former partners and accrual of retirement plan contributions payable. When financial statements are reviewed by independent CPA firms, they include notes to the financial statements. Generally, reports prepared for internal use do not include the notes.

Requests for financial reports come from both internal and external sources. External requests come from bankers and former partners or owners of the firm. Most external requests are focused on net income, the results of the firm’s operations indicated by revenues minus expenses. Banks oftentimes also require financial information regarding the firm’s owners when considering requests for loans or any lending from the bank to the law firm. Firms can have their financial statements audited by independent accounting firms to enhance the credibility of the financial statements.

When you receive an internal request for financial statements, the requestor not only wants the net income figures but also wants to know what distributable income is available. This is the amount of money available for distribution to active partners or owners. Internal reports contain not only historical data but also key operating statistics including comparisons of actual operational activity to budgets and forecasts and can contain comparisons to prior periods in time. Internal reports can be prepared as often as monthly while external reports are generally prepared quarterly or monthly.

Statement of Net Assets (Balance Sheet)

The statement of net assets (or balance sheet) reflects the financial condition of the firm on a given date or point in time. This report contains three distinct sections:

  • Assets: Current, Fixed or Other
  • Liabilities: Current and Long Term
  • Net Worth (or Equity)

Assets are the resources owned by an entity.

Current assets are those resources that can be converted to cash within the current accounting period, which is typically one year. Current assets include:

  • Fees receivable and unbilled: amounts that are owed to the firm – in accrual accounting these are added to the financial statements. With the modified cash basis, they are not added but are often included in notes to the financial statements
  • Cash and short-term investments: liquid assets held in bank accounts or invested in commercial paper or other investment vehicles that are readily convertible to cash
  • Prepaid expenses: assets, such as rent, paid in advance, that lose value or usefulness in the near future
  • Client disbursements receivable: case-related disbursements for items such as expert witnesses, travel, copying costs and court reporters. When using the modified cash basis of accounting some disbursements are considered receivables and some are considered expenses. The Internal Revenue Service (IRS) has specific rules governing the deductions of matter related expenses made on behalf of a client.

Fixed assets include property, plant and/or equipment that are long-lived items that are not turned into cash in the accounting period or within one year. Fixed assets are generally subject to depreciation and can include machinery, computer equipment, leasehold improvements and buildings. Fixed assets that do not decrease over time are not subject to depreciation and remain on the books for as long as the firm owns the asset. Fixed assets that do not depreciate include land and artwork. In some instances, deposits, patents and goodwill are considered fixed assets, and sometimes they are considered other assets.

Depreciation can be reported by multiple methods. The method selected should provide a clear, reasonable and systematic allocation of assets in the periods benefited. When determining the appropriate method of depreciation, you should consider the cost of the asset, the estimated residual value and the estimate period or life of the asset. Some items have no residual value. Suggested life estimates for many items are available from the Internal Revenue Service. The methods most common are straight-line, declining balance and sum-of-the-yearsdigits. To avoid keeping two sets of books, most law firms use the same depreciation method for both internal reporting and tax reporting.

The Internal Revenue Service has rules on depreciation. One of the more common is the Modified Accelerated Cost Recovery System (MACRS). This allows a more rapid depreciation of assets than other options.

Other assets may include merchandise held for sale, supplies, equipment, buildings and land.

Liabilities are the amounts owed by the firm. Both current and long-term liabilities are reported on the Balance Sheet.

  • Current liabilities are those due within the accounting period or within one year. Accounts payable are expenses that have been billed to the firm.
  • Accrued expenses are debts incurred but not billed. This can include salaries, rent and interest.
  • Long-term liabilities are debts that take longer than one year to repay.

The firm’s (or owners’) net worth or equity is determined using the accounting formula

Assets – Liabilities = Equity.

Ready, Willing & Able, Attorneys at Law

Statement of Net Assets (Balance Sheet)

as of December 31, 20XX

ASSETS Modified Cash Accrual
Current Assets
   Cash and Short-Term Investments 475,000 475,000
   Account Receivable 1,000,000
   Prepaid Expenses 125,000 125,000
   Work in Process 450,000
   Disbursements Recoverable from Clients 225,000 225,000
Total Current Assets 825,000 2,275,000
Fixed Assets
   Furniture, Fixtures and Equipment 225,000 225,000
   Leasehold Improvements 200,000 200,000
   Artwork 75,000 75,000
500,000 500,000
  Less Accumulated Depreciation (225,000) (225,000)
Total Fixed Assets 275,000 275,000
TOTAL ASSETS 1,100,000 2,550,000
LIABILITIES & EQUITY
Current Liabilities
     Accounts Payable 225,000
     Accrued Expenses 65,000
     Retirement Plan Contributions Payable 200,000 200,000
     Current Portion of Long-Term Debt 125,000 125,000
Total Current Liabilities 325,000 615,000
Long Term Liabilities 200,000 200,000
TOTAL LIABILITIES 525,000 815,000
Equity
     Partners’ Capital Accounts (Paid in Capital) 200,000 1,025,000
     Partners’ Current Accounts (Retained Earnings) 240,000 650,000
TOTAL EQUITY 440,000 1,675,000
TOTAL LIABILITIES & EQUITY 965,000 2,490,000

Statement of Revenues and Expenses (Income Statement)

A firm’s income statement or Profit and Loss (P&L) statement provides information about the firm’s sources of revenue and expenses over a period of time. This statement should include:

  • Revenues – sources of incoming receipts such as fees
  • Operating expenses – salaries, payroll taxes, employee benefits, rent, insurance, depreciation and if appropriate vehicle expense
  • Operating profit – gross profit minus operating expense
  • Other income – income from other sources (sale of an asset)
  • Other expense – costs such as interest or loan pay-off cost
  • Net income/loss – revenue minus expense plus or minus other income/expense. This number is sometimes referred to as the “bottom line” and is generally the amount of revenue available for distribution to the partners.

Ready, Willing & Able, Attorneys at Law

Statement of Revenues and Expenses (Income Statement)

for the Year Ended December 31, 20XX

Modified Cash Accrual
Revenues:
   Fees 4,275,000 4,400,000
   Other Income 14,000 11,000
   Interest Income 1,950 1,950
     Total Revenue 4,290,000 4,412,950
Expenses:
   Professional Compensation 739,000 727,000
   Support Compensation 755,000 762,000
   Occupancy Costs 415,000 415,000
   Office Operating Expenses 205,000 207,000
   Professional Activities 170,000 168,000
   Retirement Plan Contributions 155,000 155,000
   Other Operating Expenses 96,000 105,000
     Total Expenses 2,535,000 2,539,000
Operating Income 1,755,950 1,873,950
Payments to Former Partners 150,000 150,000
Net Income 1,605,950 1,723,950

Cash Flow Statement

Your cash flow statement should tell a story. The statement should clearly reveal the inflows and outflows of cash during a given period. You should describe the source of the cash and how it was used. Cash flow statements are organized by the type of business activity involved. Operating activity, investing activity and financing activity are the business activities reflected in cash flow statements.

A cash flow statement starts with the firm’s net profit at a given point in time and then you add or subtract from that. You can use a cash flow statement to compare year to year or any other period including month to month. A cash flow statement also reveals the amount of cash a firm has available to satisfy its debt.

Cash flow from operating activities can be created by:

  • Net profit
  • Depreciation
  • Status of clients’ disbursements receivable (increase/decrease)
  • Status of prepaid expenses (increase/decrease)
  • Status of accounts payable (increase/decrease)

Cash flow from investing activities can be created by:

  • Purchase of plant and equipment
  • Sale of plant and equipment
  • Increase/decrease in investments

Cash flow from financing activities can be created by:

  • Repayment of loans
  • Distribution to partners
  • Borrowing

Ready, Willing & Able, Attorneys at Law

Cash Flow Statement

for the Year Ended December 31, 20XX

Cash flows from operating activities:
   Excess of revenue over expenses 1,755,950
   Adjustments to reconcile net income to net cash provided

by operating activities:

   Depreciation 76,000
   Changes in Assets and Liabilities:
   Decrease (increase) in client disbursements

receivable

(225,000)
Increase (decrease) in net other assets and

liabilities

50,000
Net cash provided by operating activities 1,656,950
Cash flows from investing activities:
   Expenditures for fixed assets (120,000)
   Proceeds from the sale of fixed assets 40,000
   Purchase of short term investments (85,000)
   Proceeds from the sale of short term investments 100,000
   Net cash used in investing activities (65,000)
Cash flows from financing activities:
   Proceeds from long-term debt 50,000
   Capital withdrawals by departing partners (30,000)
   Distributions to current partners (1,480,000)
   Payments to former partners (150,000)
   Capital contributions from partners 40,000
   Net cash used in financing activities (1,570,000)
Net increase (decrease) in cash 21,950
Cash balances
   Beginning of year 378,050
   End of Year 400,000

Changes in Owners’ Equity (Retained Earnings) Statement

The Changes in Owners’ Equity Statement reports changes in all equity accounts for a given period. In a partnership, it is called the Partners’ Capital Statement. In a corporate entity, it is called the Retained Earnings Statements.

Many law firms are organized as partnerships. However, as firms get larger and more geographically spread out, there has been a move to operate as professional corporations. The structure of the firm determines the method of presenting the owners’ equity, earnings and income tax.

Financial statements of a professional corporation differ from those of a partnership only in the form of presentation and not in substance except for the income tax provision in the professional corporation.

Partnerships pass the taxable income to the partners, while corporations are subject to corporate tax before dividends are paid. Having a clear understanding of the tax implications is an important skill for a legal manager.

Another area a law firm manager must understand is the correct allocation of expenses. While firm-sponsored events that include everyone are usually 100% deductible, many other events are not. The cost of an attorney entertaining a prospective client is generally only 50% deductible for tax purposes. Charitable contributions may not qualify if the recipient does not have the correct tax standing. All accounting transactions should be carefully reviewed.

Ready, Willing & Able, Attorneys at Law

Retained Earnings Statement

For Year Ended December 31, 20XX

Retained earnings, January 1, 20XX………………. $26,320.00
Net Income for year………………………………………. 45,980.00
Less dividends……………………………………………… -0-
Increase in Retained Earnings……………………….. 45,980.00
Retained earnings, December 31, 20XX…………. $72,300.00
             Form of Presentation
                                       Partnership

Statements

Professional

Corporation

Statements

Owners’ equity Partners’ capital account Common stock and paid-in capital
Partners’ current account Retained earnings
Owners’ earnings Partner’s share of income Compensation of members Dividend distributions
Owners’ income tax Taxes are not recorded at the firm level; Partners are taxed individually on the distributions received from the partnership Firm’s income tax provision on corporation’s earnings

General Accounting Procedures Summarized

  • Generally Accepted Accounting Principles (GAAP) are the rules and standards used by accountants to prepare financial statements in the United States. Most law firms use cash basis accounting or modified cash basis accounting rather than the accrual method used by GAAP.
  • The equations that are the basis of most financial reporting are net assets, revenues and expenses, and cash flows.
    • The Statement of Net Assets (Balance Sheet) reflects the financial condition of the firm on a given date or point in time.
    • The Statement of Revenues and Expenses (Income Statement) or Profit and Loss (P&L) Statement provides information about the firm’s sources of revenue and expenses over a given period.
    • The Cash Flow Statement provides information about the inflows and outflows of cash during a given period.
    • The Changes in Owners’ Equity (Retained Earnings) Statement report changes in all equity accounts for a given period.

Banking/Investment Policies

Introduction

Law firms are businesses. Like any other business, law firms need money to run their business, pay their employees and handle funds on behalf of their clients. They use a variety of bank accounts and services to do this.

This section includes the following topics:

  • Bank Accounts
  • Banking Services

Bank Accounts

Law firms need at least three separate bank accounts. Some firms need more.

  • Operating account – used for the day to day expenses and as a repository for incoming earned revenue
  • Payroll account – used for payroll, payroll taxes and sometimes for funding employees’ pre-tax benefits
  • Trust account – used for payments received on a client’s behalf and for payments received in advance of work being performed

Banking Services

Like many businesses, law firms use a variety of banking services. A legal manager could be responsible for establishing and monitoring accounts, applying for loans, making deposits and managing the firms’ banking relationships. You should be familiar with many of the account types offered and how they can best serve your firm’s needs.

Lockbox: A lockbox is a check collection service. Your clients mail their checks directly to the bank for depositing and crediting to your accounts. The bank sends you a report each day showing the deposits. A lockbox account can speed up your check collection process and save staff time.

Zero Balance Account (ZBA): A zero balance account allows you to keep money in one account that is only drawn to the other account(s) as needed. This system is useful if you have cash in an interest-bearing account. At the end of each business day the ZBA is brought to zero by withdrawing only the amount needed from the interest-bearing account to cover the day’s transactions. This type of account removes the need to transfer funds manually from account to account.

Sweep Account: Collected balances over a predetermined amount can be swept from the firm’s checking account to an investment and/or line of credit automatically. This type of account optimizes firm funds.

Controlled Disbursement: A controlled disbursement account allows checks to be written on a specially selected partner bank. The bank notifies the firm each morning of the days’ cash requirements. This type of account allows the firm to calculate its daily cash position early enough to take advantage of market rates for investing and borrowing.

Positive Pay: Positive pay is another cash management tool and one of the leading methods of deterring check fraud. Positive pay allows the firm to upload its daily checks directly to the bank, authorizing the bank to pay only those checks. A daily reconciliation is done. This helps prevent fraudulent checks from being paid.

Salaries and benefits are usually the largest expense items in a law firm. Rent or occupancy generally is the second largest expense. The ability to record and track all salary-related cost is required. Often a law firm maintains separate bank accounts for the holding of the pretax benefits withheld from the payroll. Employees elect to reduce their compensation by predetermined amounts each pay period. The collection and reporting of these benefits is an area that requires close attention and monitoring by law firm management. Failure to record and/or pay these benefits properly can result in substantial penalties. The use of a third party for payroll does not reduce the law firm’s obligations or exposure to risk.

Banking/Investment Policies Summarized

  • Law firms need a minimum of three accounts in conducting business:
    • Operating account – Day-to-day expenses, incoming earned revenue
    • Payroll account – Payroll, payroll taxes, pretax benefits
    • Trust account – Payments received on a client’s behalf or in advance of work being done
  • Law firms use a variety of banking services to manage finances:
    • Lockbox – Check collection
    • Zero Balance account (ZBA) – Transfer money from one account to another only as needed
    • Sweep account – Collections over a set amount are moved (“swept”) from a working fund to an interest-bearing fund.
    • Controlled disbursement – Firm is notified each morning of cash requirements. Allows firm to take advantage of market rates for investing and borrowing
    • Positive pay – Bank authorized to pay only checks uploaded directly, with daily reconciliation, to prevent fraud.

Trust Accounting

Introduction

All law firms maintain trust accounts to provide separation of the firm’s funds from the clients’ funds. State Bar Associations have different rules, but all require the complete separation and detailed recordkeeping of the client funds. A law firm’s owners can delegate the day-to-day monitoring and maintenance of the trust account(s) to employees but cannot remove the responsibility that remains with the attorneys. Detailed, accurate and current recording and reporting is essential. Most State Bar Associations require monthly reconciliation.

This section includes the following topics:

  • Trust/Escrow Accounts
  • Interest Earned

Trust/Escrow Accounts

Client funds are never comingled with firm funds. Each transaction must show the initial deposit into the trust account and how that deposit was ultimately distributed. No funds from a trust account can be distributed until the actual deposit has cleared the issuing bank. Some states require the consent of the client before any distribution can be made. Many State Bar Associations can and will impose strict sanctions on attorneys who fail to manage and document properly the activity through their trust accounts.

Trust accounts are sometimes referred to as escrow accounts. Only partners or owners of a law firm should sign trust account checks. In most situations, more than one signature is recommended. The person signing trust account checks should not be the person reconciling the account.

Interest Earned

While every State Bar Association has different rules, most require that interest earned on the firm’s trust account be paid to the State Bar Association. These accounts are referred to as IOLTA or Interest on Lawyers Trust Account. It is critical that a law firm manager understand the State Bar Association rules for any states where the firm’s lawyers practice. A law firm can be subject to multiple State Bar Association rules and, if those rules are not enforced, the attorneys can be seriously sanctioned or disbarred. Failure to know the rules is not an excuse.

The ABA Model Rules require the trust account records be preserved for five years following the termination of the representation.

Trust Accounting Summarized

  • Client funds are kept separate from the firm’s funds with Trust or Escrow accounts.
  • Interest on Lawyers Trust Account (IOLTA) is paid to the State Bar Association in most cases.
  • State Bar Association rules are different in every state. Failure to comply with those rules can lead to attorneys being sanctioned or disbarred.

U.S. Federal Payroll and Employee Benefit Procedures and Reporting Requirements

Introduction

Law firms are businesses and, no matter what the legal structure, have reporting requirements regarding payroll, benefits and profits.

This section includes the following topics:

  • Payroll and Benefit Programs
  • Tax Reporting

Payroll and Benefit Programs

Many law firms offer flexible benefit programs. These can be traditional cafeteria plans or more recently Health Savings Accounts. Regardless of the type of benefit offered, a law firm manager must account for the dollars. Some benefits can be paid for with pretax dollars and others with after-tax dollars. Benefits paid for with pretax dollars have different reporting requirements from benefits paid for with after tax dollars. Every benefit has specific reporting requirements and failure to meet those requirements can and will result in significant cash penalties to the law firm. A law firm manager should clearly understand the tax implications and reporting requirements of all benefits offered by a law firm.

In some instances, a law firm elects to maintain a separate bank account for the processing of payroll and related benefits. The use of the third party for payroll processing does not reduce the law firm’s exposure to risk if either payroll or benefits are not processed and reported accurately and timely.

Another area that requires caution is retirement plans. Having an unfunded or underfunded retirement plan can and has caused the dissolution of law firms. Qualified (contributions to the plan are tax deductible) benefit and retirement plans of a certain size must file annual information returns (form 5500). The Department of Labor (Title 29) requires that plans with more than 100 participants be independently audited. Coverage tests, contribution and top heavy tests are required for a plan to retain its tax qualified structure.

Tax Reporting

Taxes withheld from payroll must be deposited on a regular and timely basis. Federal and state income taxes, Social Security and Medicare taxes are required to be withheld from all cash compensation paid to employees. You can obtain the current withholding tables from IRS Publication Circular E and your local state and/or city taxing authority.

Usually federal, state and sometimes local quarterly payroll tax reports must be filed by the law firm. The deposit schedule is determined by the size of the payroll; penalties are assessed for untimely filing. W-2s are filed with the Social Security Administration annually.

What we refer to as the Affordable Care Act is two separate pieces of legislation; the Patient Protection and Affordable Care Act (P.L. 111-148) and the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152). The reporting requirements are complex and continue to evolve.

Law firms must also prepare and file 1099 information returns to non-corporate and non-government vendors who are paid more than $600.00 annually for services. The law firm should collect a W-9 form from the vendor which provides the necessary information to complete and file the 1099.

U.S. Federal Payroll and Employee Benefit Procedures and Reporting Requirements Summarized

  • Benefits paid for with pretax dollars have different reporting requirements than benefits paid for with after tax dollars.
  • The schedule for filling payroll tax reports is determined by the size of the payroll. Penalties are assessed for untimely filing.

Legal Organizational Structures

Introduction

It is critical for the legal manager to understand the different types of legal entities employed by law firms. You need to know how a business entity is taxed and what the legal exposure is for the attorneys. You also need to recognize that what is legal in one state may not be legal in another state. As law firms continue to expand into multiple states, this has become more important to the legal manager.

This section includes the following topics:

  • Business entities
  • Tax Reporting

Business Entities

A law firm can be formed using one of several business entities. These business entities include sole proprietorship, general partnership, limited liability partnership (L.L.P.), corporation, limited liability company (L.L.C.) and professional corporation (P.C.). The business structure selected when forming a law firm determines the type of information presented in the financial statements and what tax forms are required. The method of allocating risk is also affected by the law firm’s legal structure.

A sole proprietorship has one owner who has total and complete control. The sole proprietor files a form 1040 tax return with schedules C and SE. The greatest disadvantage to this structure is the unlimited personal liability.

A partnership is an association of two or more individuals who act as co-owners. This is the structure most utilized by law firms. Partnerships are easy to establish and can be difficult to dissolve. Articles of partnership should be carefully crafted to spell out clearly the lines of authority and responsibilities of the partners. Partnership agreements are often misunderstood. In general, general partners are jointly and severally liable for debts and legal liabilities of the general partnership. A general partner is not only liable for his or her own malpractice but also that of any other general partner. In most instances, law firms organized as partnerships are general partnerships. Earnings from this structure are presented as partners’ share of income, and partners are taxed as individuals.

Limited Liability Partnerships (L.L.P.) if permitted by state law and State Bar Association ethics rules, are more common now than in the past. The L.L.P. combines the best tax aspects of the general partnership with the limited liability aspects of a limited partnership or corporation.

A corporation is an entity created by a charter issued by a state and treated as a “person” under the law particularly as it relates to litigation. A corporation can be privately or publicly owned and usually has a perpetual or indefinite life. Regular corporations are tax paying entities. Both federal and state tax are levied on a corporation’s taxable income. In a corporation, equity is presented as common stock, paid in capital and retained earnings. Earnings are presented as divided distribution. Income tax is paid on the corporation’s earnings.

A Limited Liability Company (L.L.C.) allows the equity owners limited personal liability of company debts and legal liabilities. An L.L.C. can have one owner or many. If there is one owner, that individual can elect to be taxed as a sole proprietorship.

A Professional Corporation (P.C.) can be held by a single shareholder or a group of shareholders who are not personally liable for the debt of the corporation. Equity owners are shareholders and receive a salary like other employees. Equity owners may also receive dividends. The initials P.C. signify a professional corporation, but some states use different terminology. For example, in Florida, a professional corporation is called a “professional association” and is identified by the initials P.A.

Tax Reporting

Law firms are not typically required to pay income taxes. They are considered pass through entities. The firm’s partners or owner/shareholders of the law firm include their share of the firm’s income on their individual tax returns.

Partnerships, Limited Liability Companies and Limited Liability Partnerships typically file a U.S. Partnership Return of Income (Form 1065) together with a Schedule K for each partner. Law firms that are corporations file either a 1120S (subchapter S corporation) or 1120 (regular corporation) return.

A law firm manager must know the tax reporting requirements for the state, or in some instance many states, where the law firm practices.

Law firm management must also remain vigilant regarding economic nexus. Economic nexus broadly defined means a company is deemed to have nexus with the taxing state only if it has sales in the state. There is no need to have a physical presence in the state.

Many states are challenging prior year tax returns based on information recorded on Form 1099. It is simple for states to compare 1099 filings to state tax return filings. To respond properly to any challenge, the law firm needs to maintain a time and billing system capable of producing detailed records and location tracking of where personnel are performing services. Having this information readily available assists the firm in responding to any request.

Legal Organizational Structures Summarized

  • Choice of business structure determines the type of information presented in the financial statements, tax forms required and allocation of risk. Structures include:
    • Sole proprietorship – One owner who has total control
    • Partnership – Two or more individuals as co-owners
    • Limited Liability Partnership (LLP) – Hybrid of General Partnership and limited partnership or corporation
    • Corporation – Legal entity created by charter. Can be public or privately-owned
    • Limited Liability Company – Equity owners have limited personal liability of company debts and legal liabilities.
    • Professional Corporation (PC) – Shareholders not personally liable for the debt of the corporation
  • Tax reporting requirements vary by type of business entity as well as by state.

Special Issues in Accounting for Law Firms

Introduction

For a business to grow, it must accurately track its costs and bill its clients.

This section includes the following topics:

  • Billing methods
  • Costs
  • Billing systems

Billing Methods

Traditionally, law firms have billed by the hour for their services. This is changing, but a law firm manager needs to understand the billable hour model. Each timekeeper records time spent on each matter as the matter progresses. In most cases, the law firm prepares and submits bills to the client monthly, which should document the work done, who did the work, what the person charged and the progress made on each matter. Some firms work on a contingency fee basis, where they do not receive any money unless and until they have obtained money for the client. Even contingency fee firms should have good recordkeeping systems in place so they can determine the profitability of contingency fee work. Some corporate legal departments and governmental offices also track hours for reasons other than billing clients.

Some firms record all time, both billable and non-billable. These practices are determined by firm management and can vary greatly from firm to firm. Today most timekeeping systems are electronic and fairly easy to use. The ability to generate meaningful reports is necessary.

Alternative billing methods are common in today’s law firms. Many variables and others are constantly being developed and used, such as:

  • Activity hourly rate: A rate based on the specific activity. One rate for taking depositions and a different rate for time spent in court.
  • Blended hourly rate: One hourly rate is charged based on the mixture of partner, associate and paralegal rate.
  • Case retainer: A fee is billed at the beginning of the case and is not refundable to the client.
  • Client hourly rate: One hourly rate is charged to the client regardless of who works on the matter.
  • Court-awarded fees: Awarded to individuals based on federal and state statutes.
  • Earned retainer: Money that can be moved from a trust account to the firm’s operating account. The money has been earned.
  • Flat fee: A predetermined amount of money for a specific task or group of tasks. Generally flat fees do not include out of pocket costs.
  • Hourly rate fees: Fees agreed upon between the client and the attorney.
  • Prepaid legal services: An agreement between a client and a law firm to accept payment at a reduced rate. Generally based on a large volume of similar work.
  • Pure retainer: Money paid to a law firm to exclusive represent a client and never represent the client’s competitors.
  • Unearned retainer: Money a client pays up front which is deposited into a trust account until it is earned.
  • Value billing: An agreement between the client and the law firm on the value of specific tasks or groups of tasks. Generally, only offered to clients with a large volume of work.

The method of charging a client is not as important as the accuracy and timeliness of the information provided. A common issue in law firms is the collection of billable time. Some reports have indicated as much as 30% of a timekeeper’s time can be lost without daily, accurate recording of time. The impact of the lost time has a serious impact on a firm’s profitability.

Collection of fees can be a difficult and time-consuming process. Generally, collections are easier the sooner the bills are presented following the termination of a matter. If a law firm is billing its clients regularly and the billing process is thorough with good, clear descriptions of the work being performed, a positive impact on collections results. Clients do not like surprises. Good practice is that the attorney responsible for the client relationship should notify the client in advance if unexpected or higher than expected charges appear on a bill.

Costs

Law firms incur two common types of costs. The hard (or direct) costs which are incurred and paid on behalf of the client and the soft (or indirect) costs which are internal law firm costs.

Hard costs are not treated as expenses at the time they are incurred. They are normally recorded as an asset, client disbursement receivable, when paid and a reduction of assets when reimbursed from the client. This is a tricky area in finance and the law firm manager needs to possess thorough understanding of the tax implications of how these costs are handled.

Soft costs are normally expensed as they are incurred. Your copier lease, supplies, paper, the labor to run the machines and copier maintenance are all expensed by the firm at the time they are incurred. Some firms treat the recovery of soft costs as revenue and others prefer to offset the recovery against the firm expense.

Billing Systems

Many types of billing systems are on the market today. Most firms use a system specifically designed for the legal industry, but simple time and billing programs designed for general use work in some situations. Most important when deciding which system to purchase or use is the type of reporting you require. Another issue to consider is the cost of the system. Many of them have lots of features you may never use. You need to determine the firm’s needs carefully before you commit to any software purchase.

Electronic billing has grown rapidly in recent years. Most United States based corporations employ some method of electronical billing and matter management. Understanding how electronic billing works and making certain that it does work generally falls on the legal manager. If you are unable to bill your clients successfully you cannot get paid. Due to the complexity of electronic billing, a small industry has arisen where a law firm can pay a third-party vendor to upload (submit) its electronic bills successfully.

Many electronic billing systems are on the market. Most (but not all) rely on LEDES (Legal Electronic Data Exchange Standard) formatting to submit the law firm’s bills. LEDES is a system which requires the careful categorizing of all fees and costs into the appropriate field in what is referred to as a LEDES format. Each client has a preferred LEDES format which contributes to the complexity of electronic billings. One client may require you to include different items under the same code and another may require that those same two items be in two different codes or columns of the bill format.

There is an unlimited number of ways an electronic bill can be formatted and understanding exactly what the client requires is mandatory.

From the client perspective, electronic billing allows the client to compare charges from matter to matter, attorney to attorney or law firm to law firm.

Special Issues in Accounting for Law Firms Summarized

  • While billing by the hour has been the standard in law firms, other methods are used as well, including:
    • Activity hourly rate – Rate varies by type of activity
    • Blended hourly rate – Rate varies based on the rates of all those who are working on the case
    • Case retainer – Nonrefundable fee paid at the beginning of a case
    • Client hourly rate – Consistent hourly rate charged regardless of who is working on the case
    • Court-awarded fees – Based on federal and state statutes
    • Earned retainer – Money moved from trust account to operating account
    • Flat fee – Predetermined fee for stated task(s)
    • Hourly rate fees – Agreed upon between client and attorney
    • Prepaid legal services – Agreement for a reduced rate, usually based on volume of similar work
    • Pure retainer – Money paid to exclusive represent a client and not that client’s competitors
    • Unearned retainer – Money paid and deposited into a trust account
    • Value billing – Agreement between client and the firm on the value of specific tasks
  • Hard (direct) costs are incurred and paid on behalf of the client. Soft (indirect) costs are internal to running the law firm, and are normally expensed as they are incurred.
  • Legal Electronic Data Exchange Standard (LEDES) requires the careful categorizing of all fees and costs into the appropriate field. Each client has their own preferred LEDES format.

Chapter Summary

This chapter includes the following topics:

  • General Accounting Procedures
  • Banking/Investment Policies
  • Trust Accounting
  • U.S. Federal Payroll and Employee Benefit Procedures and Reporting Requirements
  • Legal Organizational Structures
  • Special Issues in Accounting for Law Firms

General Accounting Procedures Summarized

  • Generally Accepted Accounting Principles (GAAP) are the rules and standards used by accountants to prepare financial statements in the United States. Most law firms use cash basis accounting or modified cash basis accounting rather than the accrual method used by GAAP.
  • The equations that are the basis of most financial reporting are net assets, revenues and expenses, and cash flows.
    • The Statement of Net Assets (Balance Sheet) reflects the financial condition of the firm on a given date or point in time.
    • The Statement of Revenues and Expenses (Income Statement) or Profit and Loss (P&L) Statement provides information about the firm’s sources of revenue and expenses over a given period.
    • The Cash Flow Statement provides information about the inflows and outflows of cash during a given period.
    • The Changes in Owners’ Equity (Retained Earnings) Statement reports changes in all equity accounts for a given period.

Banking/Investment Policies Summarized

  • Law firms need a minimum of three accounts in conducting business:
    • Operating account – Day-to-day expenses, incoming earned revenue
    • Payroll account – Payroll, payroll taxes, pretax benefits
    • Trust account – Payments received on a client’s behalf or in advance of work being done
  • Law firms use a variety of banking services to manage finances:
    • Lockbox – Check collection
    • Zero Balance account (ZBA) – Transfer money from one account to another only as needed
    • Sweep account – Collections over a set amount are moved (“swept”) from a working fund to an interest-bearing fund.
    • Controlled disbursement – Firm is notified each morning of cash requirements. Allows firm to take advantage of market rates for investing and borrowing
    • Positive pay – Bank authorized to pay only checks uploaded directly, with daily reconciliation, to prevent fraud.

Trust Accounting Summarized

  • Client funds are kept separate from the firm’s funds with Trust or Escrow accounts.
  • Interest on Lawyers Trust Account (IOLTA) is paid to the State Bar Association in most cases.
  • State Bar Association rules are different in every state. Failure to comply with those rules can lead to attorneys being sanctioned or disbarred.

U.S. Federal Payroll and Employee Benefit Procedures and Reporting Requirements Summarized

  • Benefits paid for with pretax dollars have different reporting requirements from benefits paid for with after tax dollars.
  • The schedule for filling payroll tax reports is determined by the size of the payroll. Penalties are assessed for untimely filing.

Legal Organizational Structures Summarized

  • Choice of business structure determines the type of information presented in the financial statements, tax forms required and allocation of risk. Structures include:
    • Sole proprietorship – One owner who has total control
    • Partnership – Two or more individuals as co-owners
    • Limited Liability Partnership (LLP) – Hybrid of general partnership and limited partnership or corporation
    • Corporation – Legal entity created by charter. Can be public or privately-owned
    • Limited Liability Company – Equity owners have limited personal liability of company debts and legal liabilities.
    • Professional Corporation (PC) – Shareholders not personally liable for the debt of the corporation
  • Tax reporting requirements vary by type of business entity as well as by state.

Special Issues in Accounting for Law Firms Summarized

  • While billing by the hour has been the standard in law firms, other methods are used as well, including:
    • Activity hourly rate – Rate varies by type of activity
    • Blended hourly rate – Rate varies based on the rates of all those who are working on the case
    • Case retainer – Nonrefundable fee paid at the beginning of a case
    • Client hourly rate – Consistent hourly rate charged regardless of who is working on the case
    • Court-awarded fees – Based on federal and state statutes
    • Earned retainer – Money moved from trust account to operating account
    • Flat fee – Predetermined fee for stated task(s)
    • Hourly rate fees – Agreed upon between client and attorney
    • Prepaid legal services – Agreement for a reduced rate, usually based on volume of similar work
    • Pure retainer – Money paid to exclusive represent a client and not that client’s competitors
    • Unearned retainer – Money paid and deposited into a trust account
    • Value billing – Agreement between client and the firm on the value of specific tasks
  • Hard (direct) costs are incurred and paid on behalf of the client. Soft (indirect) costs are internal to running the law firm, and are normally expensed as they are incurred.
  • Legal Electronic Data Exchange Standard (LEDES) requires the careful categorizing of all fees and costs into the appropriate field. Each client has their own preferred LEDES format.

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