Most law firms are aware of state bar requirements for trust accounts, but that doesn’t prevent them from falling out of compliance. In fact, 74% of all 2015 disbarments in North Carolina resulted from trust account mismanagement. Law firms that fall out of compliance with their state bar over their trust accounts can be faced with severe penalties, including fines or, in severe cases, disbarment.
To help ensure that your law firm doesn’t become subject to penalties, here are the top four trust account mistakes to avoid:
1. Failing to Reconcile Three Ways
All law firms are required to complete a three-way reconciliation, which compares your bank balance to your trust ledger balance to the sum of your client balances at month-end. Being able to generate this report proves that you’re maintaining client ledgers for each client. It also highlights any instances where a client ledger has gone into the negative.
Law firms that fall out of compliance with this requirement typically do so in one of three ways:
Bad Bookkeeping. Law firms, especially small law firms, are not always known for having great accounting procedures. Some firms don’t even follow a reconciliation process, which automatically puts them out of compliance with this requirement. For example, during the North Carolina State Bar’s Q3 2015 random audit, 26% of the trust accounts reviewed were identified as not having completed any reconciliation.
Inefficient Software. Many law firms assume that they are doing a three-way reconciliation when they complete a reconciliation in their accounting software or spreadsheets, but that’s not always the case. Most accounting software, including QuickBooks and Excel, only provide basic reconciliation—comparing the bank balance to the trust ledger balance. They miss the third component by failing to account for and compare month-end client balances to the bank balance and trust ledger balance.
Unawareness. Some firms simply don’t know about the three-way reconciliation requirement. Trust rules are unique and extensive, so it’s easy not to recognize and meet all the requirements.
2. Failing to Maintain Client Ledgers
State bar associations require that every transaction flowing through a trust account must be included on a client ledger, with no exceptions. At any given time, you must know exactly what the balance is for each client and be able to make a client ledger report available to the state bar or your client.
This can be an issue for many small law firms, as the tools they utilize often leave them susceptible to compliance shortfalls. Most accounting software and spreadsheets think in big picture terms but fail to maintain data on a smaller scale for the client ledger. To overcome this shortfall, you are either forced to manipulate a complex software like QuickBooks into tracking client ledgers or you must go through a manual and redundant process in Excel to generate the ledgers.
3. Overdrawing Client Balances
One of the main reasons to maintain client ledgers is so that you know exactly how much money you have in trust for each client. This information goes a long way in helping you avoid sending a client balance into the negative, another mistake that is punishable by the state bar. By sending a client into the negative, a law firm is essentially borrowing money from one client to use on behalf of another. This error usually comes about in one of two ways:
Incomplete Client Ledgers. If you are not maintaining client ledgers, then you will have no idea of your individual clients’ balances. When you have no idea of what client funds are sitting in your trust account, it’s easy to cut a check and overspend for a given client.
Inefficient Software. Most software used by small law firms (i.e., QuickBooks, Excel, etc.) do not prevent you from overspending a client’s balance. There are no safeguards in place that would stop you—or even warn you—that you are about to cut a check that will cause the client’s balance to go negative.
4. Overlooking Month-End Reports
Every state bar requires that certain reports be run at the end of each month or quarter, although the specific reports, and the period covered by these reports, can vary from state to state. For example, some state bars require that a payments report, a deposits report, and a three-way reconciliation report be generated each month, whereas other states only require a three-way reconciliation to be generated every quarter. As a result, small law firms may fall out of compliance for one of two reasons:
Unawareness. The reporting requirement rules can be extensive, and small law firms often find themselves out of compliance simply due to ignorance of all the different rules and reporting requirements.
Inefficient Software. The software tools used by most small law firms do not lend themselves easily to generating the reports needed to meet state bar requirements, and this often leads to improper reporting. You would need in-depth knowledge of the reporting requirements and an in-depth knowledge of the software tool itself in order to generate the right reports, and this can be overwhelming for many small firms.
Trust management rules may be detailed and extensive, but they don’t need to be a source of constant concern. With proper trust accounting software that intuitively works to meet requirements and maintain compliance, small law firms need no longer fear penalties. They can focus their full attention on doing what they do best—serving their clients.