Managing your law firm’s accounting books and setting up a structure for bookkeeping and accounting is a valuable use of time. There are two main areas where we will focus on today’s article: law firm accounting software (a do-it-yourself method) and law firm bookkeeping (if you’re looking to outsource).
Since we try to make smart money decisions as readers of this site, we’ll be looking at this choice from the financial perspective of a law practice to make sure you’re maximizing your time and money. You’ll have many options for your small business by the end of the article, though we recommend Bench as the best use of your money and time (it’s also what I use to manage the books for this website).
What’s the difference between accounting and bookkeeping?
Accounting and bookkeeping happen at different stages while managing your small law firm’s finances. Bookkeeping is the process of tracking the cash coming into and out of your business, and it’s the foundation for proper legal accounting. Typical bookkeeping tasks are (1) recording financial transactions, (2) creating and sending invoices, and (3) running payroll. Bookkeeping happens first.
Once you’ve established good bookkeeping practices, accounting is how you use the financial data from your bookkeeping to prepare financial statements, complete tax returns, uncover financial trends and make forecasts. Typical accounting tasks are (1) preparing monthly income and balance sheet statements; (2) preparing and completing tax returns; and (3) forecasting future cash flow.
Now that you understand that bookkeeping happens first, I suggest you figure out the best way to handle bookkeeping before we move on to legal accounting.
Choosing an accounting method (cash vs. accrual)
Law firms have two options for keeping books: cash accounting or accrual accounting. You’ll need to choose an accounting method before you set up your bookkeeping. Most law firms choose to use cash basis accounting because it’s simpler.
Cash accounting is how you manage your personal finances. You recognize revenue when cash is received and expenses when money is paid. This method doesn’t use more complicated concepts like accounts receivable or accounts payable because you only count the cash as it moves into and out of your financial accounts.
Cash accounting is also beneficial because you can look at your bank balance at any time to understand the amount of money available. Since revenue isn’t recognized until the cash is paid, there are no income taxes until the money is in your bank account.
Accrual accounting is a more sophisticated method that records revenue and expenses at the time they are earned or incurred, regardless of when you receive the money. The benefit of this approach is that you have a more realistic understanding of your law firm’s income and expenses.
For example, if you’re using the accrual accounting method, you would mark a client’s invoice as revenue the moment you send it even though you might not get paid for 30 days (i.e., it would be considered an account receivable).
The downside to this approach is that your business may appear to have more cash in its bank account than it does in reality, so you’ll need to be careful about managing actual cash flow.
Which method is right for you?
Most law firms should start by using the cash basis accounting method. The IRS won’t require you to use the specific rules necessary to implement the accrual method until you’re making $10 million a year. The cash basis accounting method is easier and more straightforward, which will free up your time to work on building your practice.
Develop a bookkeeping system
Bookkeeping is the process of recording daily transactions consistently. Whether you’re good with numbers or not, legal bookkeeping is something you can master if you’re willing to spend the time to keep your records updated. Most bookkeeping tasks are things like: (1) recording debits and credits; (2) reconciling balances with bank statements; (3) completing payroll; and (4) managing financial transactions.
Bookkeeping is an ongoing task that is performed daily, weekly, or monthly (if you’re adventurous). Daily bookkeeping gives you better information about the financial state of your law firm, while monthly bookkeeping will keep you guessing.
There are only three options for managing your books:
- Do it yourself. You can use spreadsheets or accounting software to manage your books. It’s not a bad option when you’ve just opened your law firm, and your bookkeeping isn’t complicated (or the volume of transactions is low). Your primary expense will be the time you devote to bookkeeping, which keeps you from tasks that generate income for your law firm such as billing clients or developing new business.
- Outsourced bookkeeping. If you prefer to focus your time elsewhere, you can find a bookkeeping service to help you manage your books. Outsourcing your bookkeeping can be an efficient option for small to medium-sized businesses because the bookkeeping service will have a team of bookkeepers that specialize in bookkeeping. Meanwhile, you can spend time doing only the things that you can do for your business.
- Hire an in-house bookkeeper. This is only realistic once your law firm has reached a specific size.
Common Bookkeeping Mistakes
If you’re managing your books yourself, there are a few common mistakes that crop up from time-to-time and here’s how to avoid them.
1. Intermingling Personal and Business Expenses.
Anyone who has started a business has been guilty of this mistake. Intermingling expenses isn’t a fatal mistake but it causes problems for your business when it comes to claiming expenses and tracking the financial health of your business.
To make sure you don’t intermingle expenses, keep separate accounts for your business and personal expenses (e.g., separate checking accounts, separate Paypal accounts, Amazon accounts, etc.). If you make a mistake and make a personal expense in your business account or vice versa, make sure to keep track of it in your books so that it is ultimately recorded appropriately.
2. IOLTA Accounts.
As a lawyer, when you receive cash that belongs to a client, you are obligated to hold those funds in a client trust account separate from your own money. These are commonly known as IOLTA accounts (interest on lawyers trust accounts) and vary by state (and also check with your local bar association).
Trust accounting causes a lot of problems for lawyers, so, in general, you’re going to need to follow a couple of steps to ensure compliance with IOLTA rules.
First, you’ll deposit all retainer checks and similar money that belongs to a client in an IOLTA account.
Next, you’ll withdraw money from the IOLTA account and transfer it to your firm’s account after invoicing a client and receiving their approval to pay the fees.
To make sure that your bookkeeping has accounted for this correctly, you’ll need to make sure that the balance in your IOLTA trust bank account matches the amount reflected on your books for the IOLTA account.
As a secondary layer of reconciliation, you’ll also need to make sure that each client’s IOLTA balance on your firm’s books adds up to the total balance of your IOLTA bank account.
3. Forgetting Business Expenses.
Many lawyers lose track of business expenses. It makes sense. You’re busy providing legal services and developing business so that Uber expense to meet a client falls through the crack. It’s best to record these expenses as they happen but realistically there will be times when you forget.
The best solution is to open up a business credit card and to record expenses on that card, ensuring that you won’t forget them even if you are keeping up with your books on a weekly or monthly basis.
4. Making Bookkeeping Entry Mistakes
One mistake when recording your debits and credits, and your entire balance won’t add up. Next, you’ll spend 10 minutes trying to find the error. Accounting software where you download transactions can help avoid this error, as can double-checking entries as you go. The most powerful solution to this problem is taking the time to frequently update your books (or outsourcing your bookkeeping to a team that will reconcile the numbers for you).
5. Confusing paying yourself with withdrawing capital
When you take funds out of your business for personal use, it can either be classified as a capital withdrawal or as a payment for salary. These are two different types of transactions and need to be managed accordingly. Having a bookkeeping and accounting system in place will ensure that the payments to yourself are recorded appropriately as salary.
Best Bookkeeping Services for Lawyers
Our recommendation is Bench for lawyers looking to grow their practice and spend more time on revenue-generating activities such as client development or billing.
It’s also the service that I use to run this website. Why am I using it? As much as I love spreadsheets and numbers, bookkeeping is an unavoidable task that takes time and energy. Someone needs to reconcile the accounts, record the entries and make sure the records are accurate. While I could easily do that myself, I’m confident that my time is better spent in legal practice and legal billing.
Hiring myself as a bookkeeping would be an expensive waste of resources. Would you hire someone who has mediocre recordkeeping skills to manage your books for $300/hour? If that’s your billable rate, then that’s what you’re effectively doing.
Best of all, as we like to do at the Biglaw Investor, we’ve negotiated a special deal for readers of the site. If you sign up using the links on this page, you’ll get 20% off your first six months of bookkeeping with Bench. I’ve been so happy with the experience that I’m on the annual plan and my guess is that after six months of working with them, you’ll be on the annual plan too.
Best Law Firm Accounting Software
If you’re determined to manage your law firm’s books yourself, here’s the software that I would consider using:
Less Accounting. The Less Accounting approach is more of a hybrid between the do-it-yourself approach and true outsourcing. For their initial plan, you can pay a monthly fee to access their software and manage your books yourself. As your business grows, you can bring on an outsourced bookkeeping that will provide traditional bookkeeping services such as categorizing and reconciling transactions.
Quickbooks. Quickbooks is still the leader in accounting software, making Quickbooks for lawyers a reasonable first choice. Quickbooks is also the leading software for integrating into practice management software, so I can see why many lawyers would choose it. The Quickbooks pricing model is still a “software as a service” though, so you can expect to pay a monthly fee.
Xero. If you’re looking to move outside of the Quickbooks universe, Xero is a fast-growing an popular online software option. Xero is substantially cheaper than Quickbooks, so it might make sense if you’re just getting started. However, the overall price difference between the various law firm accounting software isn’t significant, so I’d recommend finding software that works for you and sticking with it rather than switching software as your practice grows. There’s just too many better uses for your time.
Best Tax Accountants
Once you develop a bookkeeping system, around tax time business owners will want to consider working a CPA or professional tax accountant to handle your tax returns. While there are some outsourced services that offer this functionality, so far I’ve found that working with individuals and small accounting firms is better for this task. Here’s the list of tax accountants that we’ve vetted at the Biglaw Investor.