One of the most important decisions your law practice will make is deciding on your firm’s financial structure and management style. This decision will affect how you accept payments, manage trust accounts, and the accounting practices you will use to reduce your taxes and costs. Not only will properly setting up your finances make it easier to file your taxes, but it will also save you money, time, and stress. Importantly, you can determine your practice’s progress at any time when you have accurate financial statements. Also, you will find it much easier to work with bookkeepers, partners, colleagues, and accountants.
Introduction to Financial Accounting
Financial accounting is the process of documenting, summarizing, and reporting transactions generated by a law firm over time. These transactions are summarized in financial reports, including income statements, balance sheets, and cash flow statements.
Financial statements are used to summarize accounts through major financial data classifications: assets; liabilities; equity; income; and expenditures. The income statement includes revenues and expenses, including the money you’ve earned and most anything you’ve spent, from office supplies to payroll.
Basic Accounting for Lawyers
For new law firms, setting up a practice is only half the job. To successfully manage and grow your practice, you need to invest considerable resources in your firm’s finances. Below are some tips to get started.
Hiring a CPA
Hiring a Certified Public Accountant (CPA) is one of the best things you can do for your law practice. This is especially important for new lawyers, young lawyers, or lawyers who have been practicing for a long time but in a larger firm where they didn’t have to manage or even worry about these things.
It’s preferable to work with CPAs that have experience working with law firms. You can find them by asking other attorneys or posting to groups, communities, or listservs. Here are some things a CPA can help with:
- Tax planning
- Financial strategy
- Tax compliance
- Internal controls
- Budgets and forecasting
- Internal controls
- Financial reporting
In many cases, your tax consultant will not also be your accountant. Tax consultants might only be hired yearly to do your taxes, make entries, and clean your books. Hiring a CPA can help you make more long-term budgeting and business decisions about your firm’s future. They can also set up a system of internal controls to help protect your firm’s assets from misappropriation or embezzlement.
1. OPENING A BANK ACCOUNT
Every business operates differently, and the right bank for your business will depend on the nature of your practice and how you want to get your banking done. Here are some questions to ask when selecting the best bank for you:
- How effective is the bank’s security and fraud protection?
- What kind of fees will you be charged?
- Does the bank offer business savings accounts and credit cards? (With a business savings account, you can store money you’re keeping for taxes and unforeseen emergencies.)
After finding a bank to work with, you will want to open three accounts:
- Business savings account
- Business checking account
- Interest on Lawyers Trust Account (IOLTA or IOTA based on your state)
Ideally, you should deposit business revenue in your business checking account and transfer excess funds to your savings account for future or unanticipated expenses. Although interest rates on bank accounts are usually low, having more cash in your business savings account can increase your likelihood of securing a loan. Also, it’s a good place to save for taxes and keep an emergency fund.
When it comes to banking, it is essential to find a bank and a banker with experience working with law firms, especially if your state or practice requires trust accounts. Be sure to do your due diligence and avoid banking headaches by developing a strong and beneficial relationship with a personal banker.
2. DECIDE ON AN ACCOUNTING METHOD
Law firms must pick one of two accounting methods: cash accounting or accrual accounting. This process must be completed before your firm files its first tax return, and you’ll have to stick with that method on all subsequent returns. This decision affects tax filing, financial reporting, and how you do bookkeeping – so be sure you consult with a CPA before finalizing the method you’ll use.
Here’s a brief explanation of how they both work.
A. Cash Accounting
Cash accounting recognizes revenues when cash is received and expenses when paid. This method of accounting does not recognize accounts receivable or accounts payable.
Most law firms prefer cash basis accounting because it is easy to understand. Cash accounting makes it easy to ascertain when a transaction has occurred from your financial statements. It may still be necessary to track receivables or payables for informational purposes, but they will not appear on your financial statements. With cash basis accounting, revenue is money in the bank, and expenses are reductions to your cash balance.
Another benefit of the cash basis method is tracking the amount of cash a business has at any given time. That means you can determine the resources at your disposal by looking in your bank account, excluding outstanding deposits or checks in transit. Cash basis accounting does not include revenues earned if the client hasn’t paid, and it doesn’t include expenses that haven’t been paid or reimbursed.
Finally, cash basis accounting gives you more flexibility for end-of-year planning, because business income isn’t taxed until it has been received, and expense transactions aren’t recorded until cash is paid. Transactions are only recorded when money changes hands. This allows for the delay or acceleration of income and expenses by changing the timing of paying bills or invoicing clients.
B. Accrual Accounting
Accrual accounting records revenues and expenses when they are earned or incurred, whether or not the money has been received or paid. For example, all invoices sent to clients are recorded as revenue, regardless of the expected payment date. The advantage of this method is that it gives you a more realistic idea of (expected) income and expenses over a period of time.
The disadvantage of accrual accounting is that it does not adequately reflect a firm’s true cash flow; a firm that uses accrual accounting may seem to have money at its disposal, but in reality, its bank accounts may reflect differently. To reduce the risk of misinterpreting available funds, it is important to monitor the balances in accounts receivable (AR) and accounts payable (AP), as they appear on your balance sheet.
The accrual accounting method is more accurate, provides timely information, and is better for long-term financial decisions. Also, it is better for firms that experience significant and rapid changes in their revenues.
So, which method is right for your law firm?
Personal service organizations like law firms may use the cash method regardless of annual revenue amounts (unless they carry an inventory), but the Internal Revenue Code changes often, so it is important to consult with your tax accountant before making a decision. If you choose or are required to change accounting methods, it is possible to request approval from the IRS by filing an Application for Change in Accounting Method.
3. DEVELOPING AND MASTERING A BOOKKEEPING SYSTEM
It is critical to provide up-to-date and accurate financial statements for a CPA to work effectively. This is where the value of bookkeeping comes in, and every lawyer needs to understand the role of bookkeeping in their business.
The recording of daily transactions in a consistent way is known as bookkeeping. It is a major component of building success. To put off bookkeeping means you’ll have to catch up with it at the end of the month, or worse – at the end of the year, and that will be more stressful and time-consuming.
The following tasks are included in bookkeeping;
- Posting of debits and credits
- Data entry of all financial transactions
- Generating financial reports
- Bank reconciliations
- Recording sales and producing customer invoices
- Maintaining and balancing general ledgers, subsidiaries, and historical accounts.
- Recording expenses and receiving vendor invoices
- Preparing payroll
You can keep your books daily, weekly, or monthly. However, you have to provide accurate and updated information for your CPA. There are options to have your bookkeeping done on time and accurately, and they include:
Do it yourself: You can use spreadsheets or simple accounting software (QuickBooks, FreshBooks, Xero) to keep your books. This method is fine while your firm’s bookkeeping is simple.
Outsourced bookkeeping: As your law firm grows, the tasks will pile up, and it makes sense to manage your time by focusing on other parts of the business while outsourcing your law firm’s bookkeeping to an expert.
Hire an in-house bookkeeper: It’s proper to hire an in-house bookkeeper when your business has grown enough to afford a part-time or full-time bookkeeper on payroll. They can handle everything, including billable hours and receivables.
You can adopt the right bookkeeping method for your firm’s needs by considering the volume of bookkeeping that needs to be done, how much time you have to complete the tasks, the suitable pricing for you, and finally, how confident you are in handling your bookkeeping yourself.
A. Income Statement
Also known as a statement of operation, statement of financial income, or profit-and-loss statement. An income or operating statement is a financial statement that shows a company’s income and expenses. The income statement reflects whether a law firm is making a profit or loss over a period. You can understand the financial health of your practice through the income statement (together with the balance sheet and cash flow statement).
The income statement helps law firms decide if they can generate profit by decreasing costs, increasing revenues, or both. It also grades the efficiency of the strategies employed by the firm at the beginning of a financial period. Business owners and other executives can reference this statement or document to assess the success of their strategies. And depending on the outcome of their analysis, they can provide solutions to increase profit.
The income statement provides other information like the status of revenues, pinpointing irregular or inconsistent expenses, and overall company performance.
Usually, the two primary groups of people that use the income statement are internal and external users. The internal users include company management and the board of directors, while the external users are tax and accounting professionals, creditors, and consultants.
B. Balance Sheet
A balance sheet contains details of a firm’s assets and liabilities at any given period. It is one of the core financial statements used for assessing the health and performance of a law firm.
Through the balance sheet, law firm owners will have a solid understanding of the firm’s financial health, and can compare current assets and liabilities. When compared, the company’s liquidity can be ascertained, and the rate at which the company generates returns can be calculated.
Another benefit of comparing balance sheets is that you can determine how much a business has grown over different points in time. With this information, law firm owners can predict the firm’s future. For example, loans can be easily assessed when a firm has a healthy and creditworthy balance sheet. By noting the difference between current assets and current liabilities, creditors can predict if a company can fulfill its short-term obligations and the magnitude of the risk they’re taking.
A standard balance sheet consists of:
- Assets that are classified as current or fixed assets, tangible or intangible assets, and operating and non-operating assets.
- Liabilities – These can either be classified as current or non-current liabilities.
- Owners Earning/Equity – This is the difference between assets and liabilities. It is the net amount transferred to the shareholders after the assets have been liquidated and the debts have been paid. Equity is a common way to represent the net value of a company. A positive equity value means the company has enough assets to pay off its liabilities, and a negative equity value means the liabilities exceed assets.
C. Cash Flow Statement
A cash flow statement is a document that aids in finance management by tracking an organization’s cash flow to help in making accurate cash forecasts.
This financial statement helps in the monitoring of the cash sources, as well as incoming and outgoing money. Incoming cash can come from operating, investing, and financing activities. The cash flow statement also reveals cash outflows, investments, and expenses paid for business activities at any given period.
The primary user of the cash flow statement is the management, and it is beneficial in regulating business operations by making informed decisions. Other benefits of the cash flow statement include:
- Helps stabilize optimum cash balance
- Gives details about spending
- Develops focus on cash generation
- Useful for short-term planning
4. DETERMINE HOW YOUR FIRM WILL GET PAID
Although every state differs in its rules regarding payment processing for law firms, most state bar associations support credit, debit, and the various electronic forms of payment. You should consult your bank, state bar association, and CPA to determine what kind of payments your firm will accept. Once that has been done, the next step is to decide which payment provider you’ll work with.
The fee structure for every payment provider differs, and before you decide, ensure you know your numbers and the effect of the provider’s fee on your bottom line.
Regardless of the growth of electronic and online payments, attorneys have to be careful when deciding on a merchant processor for their firm. It’s worth noting that an average payment processor charges a percentage per transaction as a payment fee, which increases the risk of breaking some trust accounting laws. So pick a payment processor that is law firm-friendly, and most certainly, rules-compliant.
5. SET UP PAYROLL
If your firm plans on hiring employees, then you have to set up payroll. Before including anyone in your payroll, ensure your workers are grouped as either employees or independent contractors. This is quite important, as you could be fined by the IRS for any errors.
You also need to understand your responsibilities regarding employment tax and employment law fully. This is essential, especially in paying workers’ compensation insurance and mandatory disability. Be sure to consult with your CPA to get this right.
6. TAX OBLIGATIONS
Typically, businesses pay a variety of taxes across federal, state, and local levels of government. Your business tax obligations are dependent on several factors like your legal structure, geographic location, your products and services, as well as how your business operates. You will want to work with your bookkeeper, account and/or tax specialist to make sure you are paying all required taxes.
Conclusion
Lawyers looking to launch their practices, or maintain a successful one, need to pay attention to firm finances. You can determine if you are up to date on best practices by asking your accounting professionals simple questions regarding tax obligations, business insurance, payroll, and more.
About the Author:
Paul Garibian is the president of Nota, M&T Bank’s fintech platform that provides business banking solutions for attorneys managing solo and small law firms. Contact him at paul@trustnota.com.