There are two primary types of accounting methods: accrual and cash accounting. The accrual method reflects income when it is earned, while cash accounting reflects income only when it is received. Most small and solo law firms prefer the cash accounting method because, from a financial management point of view, this is more manageable. But regardless of which method you choose, there are a few accounting and financial management problems common to both methods. Therefore, before you hang up your shingle, you should carefully consider and address these issues.
Time Demands Issues
The first common accounting problem is the issue of time. Keeping good accounting records requires time and diligence. As a manager of a small practice or a solo practitioner, however, time is one thing you do not have much of. Therefore, a good way of addressing the time issue is to hire a small business accountant to do your accounting for you. A business accountant will, for example, help you develop an accounting schedule and adopt best practices for your law practice or firm. Your business accountant will also initiate and perform your law practice's periodic audits, saving you the time and effort of having to do these tasks yourself.
For some practitioners, however, the cost of hiring an accountant may be prohibitive. If this turns out to be the case for you, then it is best if, even before you start your practice, you devise and religiously follow an accounting plan. There are several good self-help books on the market regarding the best accounting practices for a small business, and many of them are helpful. But, generally a good accounting plan will consist of allocating a portion of your time each week to making sure that your expense and revenue records are current and accurately reflect your business activities for the week. This will demand time.
Cash Flow and Collection Issues
The second common problem has to do with cash flow and collections issues. Naturally, good accounting practices can reveal deficiencies in cash flow and collection models which will in turn enhance your law practice's profitability. For instance, regular and frequent cash flow analysis will alert you to any variable expenses, such as overhead costs, that can be trimmed or that needs greater allocation. Regular cash flow analysis will also give you a current picture of your accounts receivable. If, for instance, you find an upsurge in accounts receivable, that trend may be a good indication that perhaps you should change your fee structures and arrangements to minimize your exposure to bad debt.
A regular cash flow analysis can also reveal collection issues. Collection issues can be especially prevalent for small and solo practitioners. This is because, as a small practice, your client base may not be sufficiently established or liquid enough to pay their legal bills on time. Sometimes even, they may just default on your bills. When they do, your collection problems become an issue of writing off bad debt. Under these circumstances, your law practice should already have in place a procedure for writing off bad debt. Depending on the circumstances and nature of the debt, writing off a bad debt could have some tax advantages. You should discuss the matter with your accountant or a tax lawyer to find the best procedures for writing off bad debt.
Error and Fraud Issues
The third common accounting and law management problem is the issue of error and fraud. The data suggest that the frequency of fraud is low among small businesses, with about 30 percent of all corporate frauds occurring in small businesses. Of course, that number is virtually zero with a solo practice. However, regardless of how infrequent the issue of fraud may be as it relates to your law practice, there is still the potential for fraud, and unintentional accounting errors can prove costly. As a result, your internal accounting controls and practices should address the issue of error and fraud. Common sense preventative measures are effective and may include, for instance, limiting the on premise availability of cash, funneling the processing of all inbound payments through one staff member, and carefully reviewing all audit reports. Technology can also be your ally in this regard. Commercial, automated detection software programs are available. These software packages can quickly analyze financial data, flagging any anomalies or errors.
Management and Ethical Issues
The fourth, but certainly not final, common accounting problem with either cash or accrual accounting is a mixed bag of law firm management and ethical issues. This problem has to do with accounting for your client's property. All jurisdictions impose an ethical duty on lawyers to safeguard their clients' assets. A client's money, of course, is considered client-asset. As a practitioner, you will inevitably handle your client's money in various forms. For instance, you may have to act as a temporary custodian of a settlement payment to your client or your client may make an initial retainer deposit to you in a matter even before you actually start earning a fee.
However you come by your client's money, you are under a strict ethical obligation to safeguard that money by properly keeping and accounting for it. Because of this duty, you cannot commingle client funds with your business or personal funds. Therefore, your law practice accounting and management model should have clear rules and policies in place for how your law practice handles clients' money. Also, be sure to check with your state and local bar associations for specific rules regarding client trust accounts.
The bottom line is this: regardless of whether you choose the cash or accrual basis of accounting for your law practice, there are important common issues to be considered. The level of commitment and detail you give to these issues will in large part determine the success of your law firm's accounting and financial management model.