Terminology for Law Firms - What you need to know as the accounting firmNov 28, 2021
There is a lot that goes into accounting for law firms. It is essential to know these simple accounting terms in order to do the work necessary when working with attorneys.
In this article, we will dive deep into educating you on the importance of tracking finances. Accounting is just basically that. It's much better to track your finances and forecast towards goals than randomly hoping your client's law firm is profitable.
A firm's finances revolve around two main categories:
Assets and Liabilities
What is a debt or liability? A debt or liability is a company's responsibility to pay in the future. Liabilities include loan payable, payroll liabilities accounts payable, mortgages, and your client trust liabilities.
What is an asset? An asset is something that is owned by the company or company account and has value. Assets include: the law firm's operating account or cash on hand, Accounts Receivable, Fixed Assets, or Current Assets are assets that can be converted into cash in less than a year.
General Accepted Accounting Principles (GAAP) are accounting concepts that can be hard to understand, but they're essential, and you'll need to have them down if you handling the books for others. The following is a basic summary of three critical concepts in accounting:
GAAP requires a financial statement to be prepared in a systematic and organized form. These principles exist to increase the reliability of financial data. Accounts must follow strict rules and guidelines regarding any GAAP work.
There are three methods for doing the accounting for an attorney. Accrual method, cash basis, or modified which is sometimes called hybrid method.
- Accrual method: the accrual method gives you an accurate picture of your accounting records. With the accrual method, you will have invoices or accounts receivable and bills and accounts payable. Your income is calculated using the total of the invoices on the books in a current fiscal year. Most law firms, in my experience, do not use the accrual method. We typically will show the records in an accrual method throughout the year.
- Cash basis: this is the method most attorneys and law firms use for their records at year-end and at tax time. Income is derived from the payments or money received and not from invoices or unpaid like in the accrual method. So in this method, there are no accounts receivable and no accounts payable. There are accounts receivable and delinquent invoices at year-end in the real world for an attorney or a law firm. An adjustment will need to be made on the books to disregard that to produce the financial statements for the tax professional to process taxes.
- Modified or hybrid: This is the method that we use because we will let an attorney see their records on an accrual basis during the year for that accurate picture. And then we swap it to cash for tax purposes. With regard to Lawyers and law practices using this method, it is the one recommended by the IRS. See this publication for more details. Because they're going to be reimbursed, they are never a client expense unless they are not reimbursed. They would set up an asset account called advanced client cost.
The Balance Sheet
Being familiar with different accounting terms is essential with working with your clients. You need to keep track of where they stand financially, no matter how big or small the law firm is. A balance sheet summarizes your client's company's assets, values, and how much money the law firm owes.
The Profit and Loss
How it is used: A profit and loss statement summarizes your client's company's financial performance and identifies the money made or lost by the company in a snippet of time which we call the fiscal year. An income statement is a summary of the law firm's financial performance.
Debits and credits
When you don't live in a world of accounting, this one can trip you up. Especially if you look at your bank statement, which is the opposite of the world we accountants live in.
Credit accounts: Your income is a credit account. So any sales or revenue will be increased if you credit them. As we examine the balance sheet, the "credit" accounts would be your credit card accounts and loans. Your trust liability accounts will have a credit balance. Every time you receive a retainer, it is credited to the client's ledger.
Debit accounts: Your expenses are your debit account. They increase when you debit them. When looking at the balance sheet, the debit accounts would be your assets. Your bank accounts would have a debit balance if they had a positive cash balance. Additionally, anything in the client's advanced cost would have a debit balance.
I hope this article helps demystify some of the terminologies that accountants like to use. It's helpful to have an understanding of this when working with attorney clients.
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