California's oversight asks for records. What those records consist of, how client deposits are treated on the books, and how costs paid on a client's behalf are recorded.
Some of the money a law firm collects is not income. The firm keeps a separate bank account solely for client funds, money held on deposit and refundable to the client. As funds are withdrawn, each payment is coded to an expense if applicable and to reduce that client's trust balance. When the firm is paid, the money is transferred from the trust account to its regular business account, and that is when it is declared as income. Jeff Kohn, CPA
Audits were less common in previous years. An examination often came about when something prompted it: a client complaint, a bank report of an insufficient funds item or a fee dispute.
That changed in 2022 when California adopted new oversight rules following a review of past mishandling of client funds.
Firms of many sizes have been found missing one or more of the records those reviews ask for.
All deposits and withdrawals.
Each client's deposits, disbursements, balance.
Every month, for the trust account.
The checks behind each disbursement.
Bank, books, and client ledgers agree.
Ordinary bookkeeping asks what a transaction was for. IOLTA bookkeeping asks the same question and one more: which client the money belonged to.
Under cash basis bookkeeping, money received is ordinarily recorded as Income on the date it is received. A client's advance deposit into an IOLTA account is the exception. The money stays the client's while the firm holds it.
The Trust Bank Account appears as an Asset. A Liability account for Client Trust Funds Held appears at the same figure. The Liability total is the sum of the individual client balances.
Income is recorded on the date an earned fee is transferred from the Trust Bank Account to the Operating Bank Account.
| Event | Trust Bank Account (Asset) | Client Trust Funds Held (Liability) | Operating Bank Account | Profit and Loss |
|---|---|---|---|---|
| Deposit received | + $5,000 | + $5,000 | no change | unchanged |
| Filing fee paid from trust | − $435 | − $435 | no change | unchanged |
| Firm invoices $1,200, transfers to operating | − $1,200 | − $1,200 | + $1,200 | + $1,200 Fee Income |
| Case concludes, balance refunded | − $3,365 | − $3,365 | no change | unchanged |
| After the matter closes | $0 | $0 | $1,200 | $1,200 |
The filing fee did not appear as a firm Expense, since the firm paid it with the client's money rather than its own.
A cost the firm advances from its Operating Bank Account and bills back later is recorded differently, as a Receivable from the client. A true retainer paid to secure availability sits outside all of this, since it is earned on receipt.
Cost advances come at unpredictable intervals, which makes the client name easy to postpone. Entering it at the time of payment keeps the record complete without a later reconstruction.
The three-way comparison is what catches a negative client balance early. In most instances it traces back to a timing error rather than anything more.
With one or two clients holding funds, a spreadsheet with a tab per client does the job and does it well.
Partial deposits, cost advances on different dates, transfers of earned fees, and refunds of unused balances multiply the number of places a single figure gets entered by hand.
Software built for trust accounting, or general accounting software set up with client tracking and a dedicated trust account, produces the per-client breakdown from the same entries.
Records kept in the ordinary course let a firm say what belongs to whom on any day someone asks. The attorney is responsible for the account. The bookkeeper maintains the history, and the attorney and the CPA work from it.
We do all small personal and small business bookkeeping, specializing in trust and law firm bookkeeping: per-client ledgers, the monthly three-way reconciliation, and the records a review asks for.
Schedule a free consultationJeff Kohn, CPA · jeff@fiduciarybooks.com · (510) 545-2161
Read the full article at fiduciarybooks.com/iolta