Handling client funds demands a great deal of responsibility and attention to detail. To adequately manage client funds, you need a comprehensive understanding of legal accounting. 

It comes as no surprise that this involves a lot of factors. Sometimes, it helps to have a refresher.  

To help legal professionals successfully manage client funds and stay compliant with trust accounting, we’re going back to school with this guide to legal accounting, complete with essential tips and tricks as well as do’s and don’ts.   

Law Firm Accounting 101: What you need to know

Before any law practice opens its doors and begins accepting clients (and their money), it’s vital to understand the basics of law firm accounting.  

Areas of law firm accounting 

Here are the three main areas of work that law firms must consider: 

1. Business Accounting (Back Office Accounting): Every business engages in this type of accounting to record revenue and expenses for profit and loss tracking. While the balance sheet encompasses assets, liabilities, and equity, business accounting doesn’t address fiscal matter management, a domain unique to legal practices
2. Matter Cost/Income Accounting: This is used to record client costs, cost reimbursements, and fee income in the general ledger.
3. Fee Advances/Retainers Accounting: This involves oversight of client funds held in reserve to cover legal fees and expenses, including escrow funds such as personal injury settlements and their disbursements. 

Each area of accounting has its complexities and nuances. However, for this article, we’re focusing on how to handle fee advances and retainers accounting, which covers client funds.  

The basic do’s and don’ts of handling client funds

Now that we have a solid understanding of its principles, it’s time to explore the best practices and pitfalls of legal accounting.

Do’s of handling client funds 

Do know which funds go where
One of the most important aspects to understand is the differences between types of funds. Here are some of the most common types of client funds that law firms deal with:  

• Settlement funds: most common in personal injury cases or real estate settlements; typically one deposit, which must be disbursed to one or more parties

• Unearned income: your state may allow advances or retainers to be held in operating accounts as well, so be sure to follow local guidelines properly; in most cases, this depends on the nature of the engagement (e.g., retainer agreement, etc.) 

• Advances for cost: expenses incurred by law firms on their client’s behalf during the legal representation, like court fees, travel costs, or expert witness fees 

• Third-party funds: funds that are meant for a client but sent from an insurance company or another entity to be held in trust by the law firm 

The above types of funds may be put into trust accounts. However, there are types of funds that should never go into trust accounts:  

• Personal funds: personal funds refer to funds used by the law firm; this might include operating expenses, capital improvements, and more  
• Earned income: wages and other revenues earned by the law firm   
• Payroll: money owed to employees 

These funds should never be commingled with client trust accounts.

Do track individual ledgers
In legal accounting, every penny must be properly accounted for and attached to the appropriate client and matter with which it is associated. Not doing so can lead to bookkeeping problems and ethical violations. 

Keep individual ledgers for each matter that contains its balance and transactions. Additionally, it’s good practice to have a communication system in place that allows you to keep your clients informed about the funds available from their retainer.

Do have clear processes for operating and trust accounts
Distinguishing between operating and trust accounts is critical for handling client funds—especially retainer deposits, as most legal billing systems cannot differentiate between accounts.  

To protect compliance, consider a legal-specific solution that combines billing and accounting in one system. This way, you can handle client retainers however you choose while keeping everything clean and organized.

Do regularly reconcile trust accounts
It is important to regularly reconcile your bank accounts to catch any mistakes that may have occurred. These can be keying errors or even bank mistakes. Having one program to manage your retainers (for billing purposes) and your reconciliation (for accounting purposes) is optimal.  

Otherwise, you may end up with two sets of records that don’t match. 

Using the right software can take the burden off your team by allowing you to run these reports with just a few clicks.

Do use evergreen retainers
It’s a reality of legal accounting: retainers deplete. Have a process that tracks minimum balances. Once that number is reached, immediately seek replenishment so that you are never left without a balance. There are many tools that can assist with this, including systems that can send automatic email reminders.

Do communicate with your clients
Communicate openly and clearly with clients regarding the status and handling of their funds. You can support good communication by:  

• Encouraging questions and status updates 
• Sharing billing practices openly 
• Providing regular statements 
• Answering questions promptly 

By fostering open communication with clients, you’ll build trust and minimize the risk of misunderstandings and disputes.  

Don’ts of handling client funds

Don’t mix funds
Don’t mix client funds with operations funds—even temporarily. Commingling funds can result in costly ethical and legal violations that could lead to misappropriation accusations that could cost you current and future business and damage your firm’s reputation.

Don’t neglect trust account maintenance and reconciliation
Neglecting the establishment and maintenance of separate trust accounts can lead to significant legal, financial, and reputational consequences for your firm. To avoid making this mistake, set clear, repeatable workflows in place for trust account care.  

Similarly, failing to reconcile your trust accounts frequently can cause major problems for your firm; without reconciliation, you run the risk of not catching inaccuracies or irregularities before they escalate.

Don’t allow the unauthorized use of funds
Never use client funds for purposes that are not explicitly authorized by your clients. The unauthorized use of client funds is a serious ethical and legal violation that comes with serious potential consequences like lawsuits, fines, or disbarment.

Don’t violate ethical standards
Do your utmost to avoid violating the ethical standards related to client fund management. Adhering to ABA and state bar ethical standards is crucial for your firm’s reputation and can prevent unwanted disciplinary actions or legal consequences. (Here’s more on how to stay compliant.) 

How CosmoLex can help your firm handle client funds

Legal accounting can feel daunting—managing client funds requires not only a deep understanding of accounting principles but also an efficient and organized system.  

CosmoLex offers industry-leading, comprehensive legal practice management tools that include built-in trust accounting and legal accounting software. With CosmoLex, your law firm can:  

• Streamline accounting processes with a user-friendly platform and centralized financial management of client funds
   
• Safeguard compliance with automated compliance checks that reduce the risk of human error, ensuring your firm is in line with regulatory standards 

• Make data-driven decisions with real-time financial reporting that helps manage client funds, identify potential issues, and maintain strong financial health. 

Let CosmoLex keep you compliant 

For many legal professionals, navigating this challenging terrain can sometimes feel like tiptoeing through a regulatory minefield. Still, when you have the right tools on your side, legal accounting processes can be a walk in the park. 

From automated compliance checks to ensure you’re on the right side of regulations to streamlined accounting processes that take the heavy lifting out of legal accounting, CosmoLex can provide you with the tools you need to take your legal accounting to the next level. 

Ready to see what CosmoLex can do for your firm? Watch this CosmoLex webinar to learn more!