The Chart of Accounts
The chart of accounts is a foundation of any accounting system and is usually the first thing clients ask about because they are not sure what accounts they need. Understanding what each account is, what goes in it, and how do they apply to your business is something every law firm owner and/or manager should have a grasp on whether you are doing your accounting yourself or hiring an accountant or accounting service.
A chart of accounts is an accounting term for a numbered list of the accounts that a business has in its general ledger. A typical chart of accounts application uses a three or four digit coding scheme to identify each account and differentiate the accounts by their type . The categories of accounts in accounting are: Because most law firms are service companies, typically 90% of the accounts in your law firm chart of accounts will fall into the first two categories, Assets and Expenses. This is why standard accounting software packages have charts of accounts already created for service companies and why they typically need to be modified or a new chart needs to be created for law firms and other types of businesses.
Having an accounting system that is geared for your law firm will make your work easier and more efficient. You will have the information that you need to run your business and be able to use this information to better manage your practice. When you hire an accounting company they should have a basic chart of accounts for law firms and it should be easy to modify and customize to fit your exact needs.
Law Firm Chart of Account Essentials
The essential components of a law firm chart of accounts include assets, liabilities, revenue, expenses, and equity.
Assets
Every law firm has current and long-term assets that must be tracked. Assets such as cash, receivables, and fixed assets (such as furniture, equipment, and leasehold improvements) must all have a place in your chart of accounts. This ensures that anyone reading the balance sheet can easily find these figures.
Liabilities
Accounts payable, notes payable, and advanced client fees all fall into the liability category. For clients who deposit retainers with you for ongoing services matters, those retained fees are typically recorded as deferred client fees (also known as unearned income). This type of account is considered a current liability until the client utilizes those fees. These client deposits need to be tracked and recognized when the legal service is performed.
Revenue
Most law firms’ revenue come from fees charged as the result of legal work. These cannot start showing up in revenue until the month you actually perform the legal service. That’s why they belong in their own revenue-related account in your chart of accounts. Your chart of accounts will also likely include other accounts for earned income such as interest income, which is also related to the use of your law firm’s funds.
Expenses
Operating expenses need their own accounts as well. Sometimes called "overhead" or "administrative" expenses, these also include but are not necessarily limited to IT expenses such as computer and phone equipment, licenses, subscriptions, office supplies, taxes, and professional development. It is important to consider all administrative, rent, utilities, bank fees, and any other expense necessary to keep your practice running. Your chart of accounts should allow you to see all expenses in one document, organized by account and month.
Equity
Finally, your law firm equity needs a home in the chart of accounts section of your financial statement. Corporation(s) and other structure(s), such as limited liability companies, can vary. But equity is increasing for your firm when income exceeds expenses and is decreasing when expenses exceed income. At all times, equity should be stated positively.
Designing Your Chart of Accounts
There is no right or wrong chart of accounts down to the field. The chart of accounts must be tailored to the size of the firm, the area of practice and even more specific needs. The IP attorney may need an extensive amount of subaccounts to track patents, trademarks, and fees to individuals associated with each patent or trademark. The family law attorney may need extensive accounts for trust accounting. The business attorney may just need a few accounts, depending on how they account for their costs.
If you have a larger firm or just an extensive practice, you need a more detailed chart of accounts. You are better served by breaking out general categories, i.e. "G&A – Compensation Expense – Wages," rather than lumping all wages together under "G&A – Compensation Expense." Types of accounts you may have under G&A – Compensation Expense are:
You can look at your previous chart of accounts for ideas on what accounts you may be missing or could eliminate. You probably don’t need specific accounts for each of your staff members, but may want them under "G&A – Compensation Expenses."
If you are a sole practitioner and only use a summary of expenses for income tax purposes, you may be able to get by without subaccounting in greater detail. Your accounting will likely be for tax reporting purposes only and not for analyzing your law firm’s profitability. Most CPAs will encourage you to analyze the Profit & Loss by going back and assigning the proper classes, which means adding a lot of new detail to your P&L to get there. Most accountants don’t want to do that, so you may need to give them a little help if you want them to analyze your P&L by category.
It is a good idea to prep the chart of accounts in an Excel spreadsheet first to determine the level of detail you want and to assign categories to each account. That way you can give your staff well defined tasks with a very specific list to follow, which should reduce the time your staff has to spend learning how to create the chart.
Common Chart of Accounts Mistakes
One common mistake law firms make is the lack of detail. For example, a firm might place income from all sources into one category, "Legal Fees and Income." If a firm is not detail-oriented, it might be tempted to group malpractice insurance as a category under Legal Expenses in order to simplify the chart. This would incorrectly imply that the malpractice insurance was related to a certain area of law, i.e., estate planning.
It is very important to ensure that expenses are properly categorized according to the actual activity. In this case, the malpractice expense should be placed on its own line item as "Malpractice Insurance" and then listed as a legal expense even if the firm has a relatively small percentage of estate planning.
A similar misclassifying error is placing a large portion of a contingency award in one income category. For instance, a class action product liability suit could range from $1 million to $200 million depending on how far the case proceeds through the legal system. While taking this hypothetical as a whole, an attorney should separate all income as it arrives rather than when the check is finally deposited into the firm’s account. If the work is divided into two or more separate categories, "Mass Tort Law – Class Action" and "Mass Tort Law – Individual Cases," the firm will be able to see the revenue generated by individual cases and market as needed. Some law firms find it beneficial to have "dummy" categories that allow income to be moved after it has been deposited as the attorney has a better idea of the nature of those funds. An example of a "dummy" category is "Legal Revenues."
Another common mistake made by law firms is using the direct method for accounts payable. "Direct" simply means that checks are written as bills come in. This creates an unnecessary amount of overhead as the firm will require someone to open and sort the mail. It is much better to receive vendor invoices electronically if possible. Then the firm can sort them in a database to ensure favorable payment terms. The direct method also requires the accounting department to verify that payment is received through a reliable balancing method; records have to be kept to validate what was paid, for how much and when. A much more efficient method is to pay everything out of a single trust account.
Law firms should avoid the temptation to categorize items such as payroll and any other form of tax under the same itemized section. For instance, payroll taxes should be listed separately. A great deal of information can be gained from keeping employment records as separate items, such as time worked and labor costs per individual.
ROI of a Sound COA
A well-organized chart of accounts provides several practical advantages to law firms. First, a properly structured chart enables accountants and financial professionals to prepare timely, reliable, and detailed financial statements. This allows the firm to quickly identify areas of strengths and weaknesses within a given period or against prior periods. A firm can quickly see that it has successfully grown its revenue in Area A, but profitability is shrinking due to increasing expenses in Area B. Or, it can see that labor rates have improved significantly since the last cycle, because the firm can compare the current quarter’s timekeeper revenue to that of previous periods without additional work or analysis necessary.
With a well-organized, structured chart, the firm can easily build and utilize budgets that are based on actual historical results over a specified time period and forecasted results over future periods. The firm can easily see what position it should be in after achieving its budget , and it can assign resources accordingly. Or it can freely adjust its budget if necessary. For example, the firm can decide that it wants to increase its marketing budget to more aggressively drive new business. Or the firm can decide that a particular practice area is not mean to generate significant profits, just reliable cash flow. Therefore, the financial reports can be designed to highlight net revenue and gross margin for billable hours, not how much time was spent producing the work.
A well-organized, structured chart of accounts not only helps the firm evaluate its performance against itself, but also helps the firm evaluate its performance against other firms. For example, many of the most commonly used Key Performance Indicators (KPIs) are expressed as ratios or comparisons based on accounting and financial concepts like:
These KPIs can be calculated using a well-organized chart of accounts, allowing the firm to compare itself to its own past results or that of other firms.
Software and Automation
Beyond manual spreadsheets, there are various software options available that can assist lawyers in setting up and maintaining their chart of accounts. Both sophisticated financial software and cloud-based solutions offer a variety of tools that can help streamline this process. For example, some of the recent integrations with these accounting platforms include connection to popular document management software such as NetDocuments, document creation utilities such as HotDocs and document assembly programs like Woodpecker. Integration with these programs allows tax and accounting programs to pull data directly for forms 1099, for tax calculations or for payment processing. Integration into document drafting software allows clients to use a document assistant to populate certain fields in tax documents minimizing the time and effort to complete the document and potentially reducing the chance of human error. Automation is an increasing trend in many aspects of accounting, particularly for accounting professionals who work almost exclusively with law firms. In addition to new integration points, there are also expansion of existing ones. For example, many document automation platforms have broadened what fields can be integrated into and out of their system. As noted, for completing tax documents, you can create fields for vendors first and then use those fields to pull information directly into your accounting software. This helps not only process the information quickly and easily but reduces the opportunity for human error. There are also a number of cloud-based automation solutions that help firms consolidate and streamline their reporting capabilities. They can help to pull in accounting data from multiple sources and generate exhaustive reports, giving attorneys greater insight into their practice. These tools can help encourage data democratization and break down silos. By sharing this data among practice group leaders, they can have more insight into things like profitability, efficiency, realization and realization rates — something that many times is captured but is not visible across the firm. It also provides management with greater insight to identify common areas where data is missing or where pipeline-forcing measures can be implemented to improve the quality of the information available to them and their firms. In addition to across the firm, automation can also be found in various technology tools that provide legal professionals with insights into their practice. These tools can help attorneys observe trends, judge the health of their practice and decide whether and when to make changes. For example, by connecting to other tools, legal professionals can be continually updated on time and activity billed, alerts about which matters to have conversations about and tracking the financial impact of their decisions. All-in-all, there are a number of tools lawyers can use to help them build and maintain their chart of accounts. Automation and integration can save hours of time during the setup process and day to day maintenance, providing the accuracy that lawyers need for their financial statements.
Periodic Review and Updates
Just as law firms themselves—especially those that are growing and expanding or that are acquiring (or being acquired by) other firms—are dynamic and constantly changing organizations, the chart of accounts, the company’s financial structure, must likewise change and adapt over time. For this reason, regular reviews and updates are essential, both for an accurate reflection of the firm’s activities as well as compliance with external financial reporting requirements.
Law firms need to evolve to react to changes in their practices’ needs, the industry at large, and to provide compliance with revised/updated accounting standards, whether from the Financial Accounting Standards Board , the IRS and GAAP generally.
Depending on the size of the law firm—in terms of the number of offices, legal and other personnel, types of practice areas or activities—the chart of accounts may need to be modified at intervals of:
Even if a firm is relatively small, it can implement an annual review of its chart of accounts in order to better react to those external forces that can impact its bottom line.
Financial reporting standards are always changing; keep abreast of accounting standards changes, whether for GAAP or the IRS, to learn how they can affect your chart of accounts requirements. If your firm is compliant today, it may not be in the future. Staying ahead of changes in accounting rules will help ensure that your law firm’s chart of accounts will be able to keep up.