When it comes to trust accounting (also referred to as IOLTA), having a comprehensive understanding of individual state requirements and compliance should be of the utmost importance to any trusted attorney. From maintaining meticulous records (digital and print) to recognizing the key differences between earned and unearned income, trust accounting presents several unique challenges. Though the processes involved may appear tedious, firms that fail to remain in compliance with trust accounting regulations run the risk of harsh penalties, even possible disbarment. Protect against these potential pitfalls by anticipating the common challenges associated with trust accounting compliance, and by taking full advantage of new technology for added security.
Challenge #1: Lack of Trust Specific Knowledge and Rules
Each state has its own compliance guidelines and audit programs, which attorneys are responsible for understanding. A firm’s accountant and bookkeeper(s) also must understand legal accounting. Many professional accountants are unfamiliar with the unique trust accounting challenges and compliance requirements unless they specialize in servicing law firms. As a result, firms must make it a priority to educate employees on these matters, and specifically, to establish protocols around the following issues:
- How long to wait to disburse funds after depositing a check
- How to handle receipts by credit card
- How to handle un-cleared checks and where to deposit money if client overpays
Challenge #2: Limited Resources of Small Law Firms
Especially for small firms, dedicated resources, training and IT systems may be difficult to manage. However, compliance requirements and the chance of an audit are identical regardless of firm size. As a result, it is imperative that every firm, both big and small, has the necessary tools in place to adequately handle its accounts. By taking the time to review inefficient processes and investing resources to improve them, a firm can experience significant change. Even implementing one new tool or a day of proper staff training can protect your firm from common faults. Even solo practitioners (maybe most of all) need to educate themselves in this respect.
Challenge #3: Manual Systems
Tracking client funds manually or by using loose spreadsheets is not only slow, but is also prone to error. Despite best efforts, hours may be wasted trying to track down a five-cent discrepancy, re-creating records, or writing checks and deposit slips. Even a firm using a general accounting solution must be sure it is setup properly, as such software is not designed for legal practices and requires extra vigilance. Further, it is irresponsible to wait until an audit to find out if a system is able to produce the required reports.
Regardless of the system in place, it is in a firm’s best interest to follow these general guidelines:
- Reconcile bank statements immediately upon receipt
- Have a partner open and carefully review the bank statement (even if a bookkeeper or other party will be doing the bank reconciliation) to protect against errors and frauds
- Run reports at least monthly in order to prepare for a possible audit
- Utilize a program that ties all funds back to the matter in question
Challenge #4: Commingled Trust Funds
ABA Rule 1.15, Safekeeping Property, requires the following: a lawyer shall hold property of clients or third persons that is in a lawyer’s possession in connection with a representation separate from the lawyer’s own property. Additionally, specific rules concerning allowable uses and distribution of funds must be reviewed and followed.
There are two main types of commingling:
- Losing track of individual client balances in trust accounts (i.e. no separate ledger cards). To avoid this, make sure every recorded transaction references the appropriate client matter.
- Mixing client and attorney funds (excluding what is allowed by some states, which also must be tracked separately). This can include depositing trust money into an operating account and moving it later (e.g. client send a check to cover fees and trust payment). Be aware of your state’s rules to help prevent problems.
While different trust funds can be kept in one pooled bank account, they must be recorded separately in the books. In some unique situations (for example, large amounts that will remain for a prolonged duration), it may be useful to open a separate trust account for the client. Be familiar with state rules, which stipulate the conditions of opening separate accounts and are usually based on the amount of money and how long it will be held.
Regardless of a firm’s system, however, funds must be managed by matter; this cannot be an afterthought.
Challenge #5: Trust Ledger Overdrafts
It is illegal to overdraw trust accounts at the matter level. Even if visible funds are available in a bank account, the ledger card must have a balance before a check is drawn against it. As previously discussed, if funds are commingled, the two will become indistinguishable. Unfortunately, there have been many instances of disciplinary actions due to the fact that funds were not cleared from one matter and were disbursed to another account, despite being used for genuine purposes.
In some cases, deposits to a trust account bounce or are stopped. However, as long as the state’s rule concerning how long to wait before withdrawing funds has been adhered to and the difference is made up immediately, no violation will be issued (pending remediation by the client).
Challenge #6: Absence of Safeguards to Prevent Common Trust Mistakes
Common trust mistakes that we’ve covered including commingling of funds, overdrafts, duplicate check numbers, lack of identification for each matter, can all easily occur when using general business accounting software. All fiduciary responsibility rests with the business owner, and as a result, he or she must implement the necessary systems and processes that equip the firm with the proper tools to support compliance. As the responsible party, the business owner must personally and regularly review reports to make sure matters are handled and detailed properly. This task cannot be entirely delegated and includes reviewing the bank statement, transactions, and reports showing that all exchanges are properly accounted for and documented. Of course, modern legal software can assist in providing safeguards, but in the end, a diligent, educated staff is the best defense to these errors.
Challenge #7: Un-cleared Funds Not Addressed
When it comes to a trust account, the firm maintains fiduciary responsibility until funds clear. The longer this goes on, the harder it becomes to “dispose of.” Because of this, it is important to stay attentive by reconciling monthly and running the necessary related reports. Most states also stipulate how long an un-cleared check can remain in trust before action must be taken (which may include contacting the client and if that is not possible, turning the funds over to the state in a timely manner).
Challenge #8: Sloppy Bank Reconciliation
Though bank reconciliation is always important, it is especially critical in trust management. Since trust reconciliation is different from operating accounts, “three-way reconciliation” must be performed each month. This breaks down the Book Balance, Bank Balance, as well as the Sum of Individual Card Balances (with accounting for funds in transit). By comparing what is shown on the balance sheet to the bank statement balance, any difference based on un-cleared checks and deposits can also be accounted for against the total by client/matter.
Challenge #9: Separate Billing and Accounting Systems
In most firms, billing, trust and business accounting exist independently. However, this has the potential to create a lack of communication and result in confusion, especially if/when a situation arises and one employee is handling billing and another the accounting. Much of the trust fund tracking battle is won when billing and trust accounting are combined, billing and trust bookkeeping are already intertwined in multiple areas. There are several advantages to integrating the below steps with an existing billing system, rather than trying to manage each separately:
- Client trust fund balance must be shown on billing (this varies by state, as is whether balance must be shown in detail or summary)
- As fees are earned and advance is entered into the trust account, the following needs to occur:
- Trust money must be moved to business account
- Trust balance and client ledger need to be updated accordingly
- Invoice must be marked as paid
Keep in mind, the state rules on whether trust money can be moved immediately upon billing or must wait a certain period of time. Additional restrictions may exist in fee agreement commitments, and there may also be rules requiring that what is shown on the invoice exactly matches what occurred with respect to moving money out of trust. Depending on client agreement, funds may only be used to pay fees or expenses.
Challenge #10: Lack of Controls and Data Protection
Whichever tool a firm uses, it should contain user-level access controls to designate who can perform certain actions and has access to sensitive information. Not all employees or members of a firm should have access to every part of your trust accounting system, and regulations require that firms do everything possible to keep client information and funds confidential and secure. Additional levels of protection that every law practice should put in place include:
- An audit log, which keeps a record of each team member’s activity while using the software
- Automatic backups, which are a much safer solution than copying from one machine to another or using a zip drive or similar storage device
- Two-factor authentication (2FA), which sends a verification code via SMS to a mobile device before log in
Particularly in the area of trust accounting, issues of compliance are here to stay. To provide clients with the best legal advice, it is important to establish firm-wide protocols and procedures that will safeguard against these common challenges, as well as to take full advantage of recent technological advances to enhance security. Every attorney needs to know the rules, know their specific needs, and know how to put the proper tools in place.
About the Author
CosmoLex produces cloud-based law practice management software designed to help lawyers keep track of matters and their accounting in an all-in-one platform. Learn more at CosmoLex.com.