Understanding Direct and Indirect Costs for Law Firms: A Guide for Legal Bookkeepers
Apr 24, 2023If this is your first time working with an attorney at a law firm, you will be entering client costs. The handling of these expenses differs by if they are direct or indirect. You may hear the terminology “hard costs or soft costs.”
Direct Costs/Hard Costs
Now, let's discuss handling direct costs, also known as hard costs. When a lawyer pays the cost on behalf of the client, it is considered a direct cost. These costs are posted to the extended customer cost account, which is an asset account. The money provided by law firms is seen as mini-loans that use operating capital to pay for these client expenses. This transaction should be booked in the "advance client cost" asset account to book into the accounting system. When the expense is billed back to the client, it is still booked to the same account. This ensures the transaction is not stated on the attorney's profit and loss.
Indirect/Soft Costs
On the other hand, indirect costs, also known as soft costs, are expenses that are not directly targeted toward one client. For instance, expenses such as postage and copying can be used for both the law firm's operation and clients. These costs are always booked directly to the expense account. When it's time to bill the client, the expense is booked to the billable expense income account. Unlike direct costs, indirect costs cannot be targeted toward one definitive client.
How is this stated in the Accounting Platform?
Let’s start with the basics of what you might see when you get an attorney-client. The old-school method was every client expense, and I’m talking about direct expenses, which would be booked into billable expenses. When they’re billed back, you will make billable expense income. This is where you will see that the billable, expense, and income accounts negate the billable expenses. So on a profit and loss, this was shown as a wash, in theory.
However, when it comes to advanced client costs, this is where you should be booking in the billable expenses. Remember that asset account? The transaction would be booked into advanced client cost, and when it’s billed back to the client of the law for him, it’s booked to the same account. It’s still a wash; however, it never is stated on the attorney‘s profit and loss. That’s the point.
Indirect/Soft Costs
For soft costs, those expenses not precisely targeted to one client, like postage and copying, can be used at the law firm for both the law firm's operation and clients. Those are booked directly to the expense. In the example of postage, the expense of the book, the postage expense, and then when it’s billed back to the client, it is booked into a billable expense income account.
The difference between direct and indirect expenses is that when the billable expense is targeted towards one client (advanced client cost), you can’t target the soft costs directly to one definitive client, making it a soft or indirect cost. So they’re handled differently in accounting. soft costs are always booked in this way, and I’ll probably do a whole other article on the soft costs because they are vastly different than the direct costs
Superb Workflow with LeanLaw
One of the workflows I find particularly efficient while using LeanLaw is one I affectionately call the "Look, Ma, no hands” method. This software integrates seamlessly with Dext and QuickBooks, allowing for easy receipt capture and automated billing. All you have to do is add the matter's name into Dext, and the system will push the data to QuickBooks Online, ready to be invoiced to the client in LeanLaw at the next billing cycle. The beauty of this workflow is that a copy of the bill is attached to the transaction in QuickBooks and easily accessible in LeanLaw.
Personal Injury Firms
When working with a personal injury firm, you must gather many costs over the years until the matters come to fruition. Some of these cases last multiple years, and you want to be able to target every penny because any missed expense will become a firm expense. This is why it is essential to use some billing software to keep the details in order and processed efficiently during billing.
Reconcile the Advanced Client Cost Account
The next crucial step in reconciling the advanced client cost account, which can sometimes be daunting. This step is crucial because any expenses that remain in the asset account for closed matters must be addressed. These expenses need to be journaled down into firm expenses or billed back to the client if they were legitimately missed. As illustrated in the picture below, the expenses are entered and billed out, resulting in a debit and credit that will clear each other out and reconcile. If any items remain in the account, they must be brought to the attorney's attention to be addressed, either by billing the client for the remaining expenses or by writing them down on the books as a firm expense.
Tracking these critical client expenses is far more accessible using legal billing software such as LeanLaw or Clio. Understanding the difference between direct and indirect costs is vital for proper accounting, and reconciling the advanced client cost account is crucial to ensure all expenses are accounted for. With these tools and knowledge, you can streamline your workflow and ensure accurate client billing.
We often discuss this topic at our mastermind group, the Accountant’s Law Lab. We would love to have you join us.
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