Trust accounting is one of the top challenges for lawyers. Especially solo and small firms that don’t have accounting and bookkeeping departments. This is the second blog in this series where Tom Boyle of Trust Books gives us essential pointers on trust accounting. Here we discuss trust accounting key concepts.
Trust Accounting: 7 Key Concepts
Aside from the rules on what goes in and out of the trust account we mentioned in the previous blog, there are 7 key concepts in trust accounting. These are absolutely important because you can pay huge penalties or even be disbarred if you can’t account for money that’s gone in or out of the trust account.
It’s your responsibility to safeguard and account for these funds and keep them separate from your personal and business accounts.
65% of disbarments are related to mismanagement of the trust account. That can seem alarmist, but it’s a fact. The state bar can come down pretty hard on this. It’s not something they are lenient about.
However, it’s not as scary as it seems. The seven key concepts of trust accounting will keep you within the rules and regulations, and always ready for audit. It gives you the foundation to handle 80% to 90% of the trust scenarios you come across in your law practice.
1. Segregation of client funds
Maintaining client ledgers is the very core of trust accounting. This is where tools like Quickbooks and Excel can be tough. They’re not set up to do client ledgers. You need to do a lot of workarounds.
Client funds are not for your use, your firm’s use, or for any other client’s use. Separate clients have separate ledgers, and you never use one client’s money for anyone or anything else other than that client and their obligations.
If you have ten clients in a trust account, that means you also have ten ledgers. This is important.
- Client ledgers: Every deposit, every payment MUST be assigned to a client.
- At any time, you should know how much money you have on a client by client basis. That brings us to the second concept.
2. Do not bring client ledgers into the red.
If you know how much money each client ledger has, you’ll be able to spend only what you have. You can’t spend what you don’t have.
- At no point can you bring a client ledger into the negative.
The reason why is let’s say one client has $200 in the trust account. If you were to cut a check on behalf of this client for $300, you would essentially be bringing this client’s balance into the negative by $100.
And in that scenario, you would be borrowing from a different client. That’s misappropriation of funds. Each client has only his or her funds available to cover each of their expenses. That brings us to the third key concept.
3. There’s no such thing as a negative balance.
Client trust accounts only have two scenarios:
- Positive balance
- Zero balance
Negative balance is a problem. That is a huge, huge, NO-NO. And again, this brings us to the next key concept.
4. Timing is everything.
Patience for the deposits to clear means you only spend when there are funds in the client’s trust account. You need to know your bank, when funds are made available, and deposit deadlines.
- Before making a disbursement, funds MUST be available.
You need to wait for funds to come in before writing checks or making payments against it. What happens when you do?
- The check would bounce.
- The bank would take the money out.
- You end up helping one client at the expense of another.
- Your client’s ledger goes into the red.
This ties in with the next key concept.
5. Timely recordkeeping
Now, this also depends on your bank, on when the bank reflects the funds in their online banking channels. This is intertwined with waiting for funds before disbursement AND timely recordkeeping.
- Regularly check balances to know exactly how much money you’ve got in your trust account for each specific client.
- Make sure that you’ve got a process and system in place that you can record your trust activity on a timely basis.
You need that timely basis. So if you do make a disbursement you’ve already got all the deposits and the previous disbursements recorded so you know exactly how much money you’ve got in your trust account.
You always need the info on each client’s accounts.
- running balance of the client
- running balance of the client trust account
6. Final client balance should always be zero.
You’ve tracked all the money in and out on a client by client basis. At the end of the day, that client balance needs to be zero, no more, no less.
- What comes in = what goes out
- Take care of small, inactive balances as soon as possible.
7. Always maintain an audit trail.
- Maintain an audit trail: Documentation creates an audit trail that generates transparency.
Whenever you create or update your paper trail, make sure that two, five or even fifteen months down the road, somebody else who has no background with the company and no background with auditing can easily follow the exact steps you took, use your paper trail, and reach the same conclusion that you reached.
This applies to accounting in general, and especially handy for trust accounting.
When you’re filling out deposits and payments in and out of your trust account, make sure that if the state bar comes in and looks at your records from two years ago, those records should give enough information that you and the auditor can easily see what you did on that day, two years ago.
Things should be clear not just to you, but to the audit or the state bar, so they can reach their own conclusion that matches yours.
So there you have it, trust accounting rules and key concepts. All seven concepts are intertwined and build on each other.
In the next blog post, we’ll move on to the key points of trust account reconciliations.
Sign up for Trustbooks today and get a $100 credit towards their TrustBooks subscription.