You’re on the road to starting your own law firm—bravo! You’ve already learned the legal ropes and built up a client list to support your new business, which means the hardest part is over. What’s left is the mechanics of starting and growing a business.
While you may have mastered the legal code, law school curriculums tend to be light on business management advice. Luckily, managing your business’ back office doesn’t need to be time consuming or frustrating. Start your firm off on the right foot, and tasks like expense tracking, payroll, and taxes won’t dig into your day.
The back office is important, but your time is also valuable. Streamline your processes, and you’ll kill two birds with one stone.
Your Entity Selection Matters
One of the very first decisions you’ll need to make as a new business owner is how to incorporate. Will you file as a sole proprietorship, partnership, S Corp, C Corp, or LLC? There are pros and cons to each entity type, particularly surrounding taxes. Sole proprietorships and partnerships, for instance, are pass-through entities, meaning business taxes and personal income taxes are filed together.
Many law firms opt to file as S Corps so they can pay themselves a wage and avoid the “double taxation” that comes with being paid as a shareholder. Corporations are more complicated to file for than other entities but offer a high level of liability protection.
There is a lot to consider when choosing your entity type. Working with a fellow attorney or tax accountant when making this decision will help you make sure that you’re sufficiently protected as a business owner and that you don’t pay more in taxes than you need to.
Keep Accounts Separate
One of the easiest ways to bring on unnecessary headaches is to accidentally mix up your personal and professional finances. From the get-go, set up a business bank account that will handle all of your business finances—and nothing else.
When reconciling your books down the line, trying to figure out which transactions are actually personal expenses takes up a lot of time. Rather than trying to track down receipts or going through bank statements line by line, the best thing you can do is to get set up with a separate account, separate credit card, and separate checks for your business. Keep those things in separate locations if you need to.
When it comes to accounting, mixing up your accounts is a headache. But if your firm is required to keep a trust account, mixing up accounts can put your license into jeopardy. So it’s good practice to get in the habit of maintaining your separate accounts from the very beginning.
More on Trust Accounts
If you do need to maintain a trust account to keep your clients’ payments before work is completed for them, remember that they are not the same as your everyday checking account. You will likely need to visit the bank in person to open one, and they should walk you through a very specific process for opening an account.
If the bank tries to push you toward opening a regular checking or savings account and moving on, you may be able to call a resource line and chat directly with someone who can guide you (and your banker) through the process.
The consequences of mishandling a trust account are steep. So you don’t want to take any chances. If you do occasionally mix up personal and professional finances, it may be a smart idea to open your trust account at an entirely different bank to help avoid the risk of a mishap.
Profit First Accounting
On the flip side, some law firms take the separation of accounts to the opposite extreme, opening several accounts to help them organize their money. Profit first accounting is a relatively new concept that’s picked up steam with law firms and flips the typical accounting equation on its head. Instead of Revenue – Expenses = Profit, profit first accounting uses the equation Revenue – Profit = Expenses.
What this concept does is help to curb expenses by making profit goals “non-negotiable,” and the way it’s put into practice is by opening different bank accounts. Business owners may open checking accounts for revenue and operating costs and savings accounts for profit, taxes, and their own take-home pay. In other words, as money comes into the business, some of it is more or less earmarked for “profit” and moved into the appropriate account.
This way of accounting is really more a way of thinking. It’s a philosophy. And if using a sophisticated accounting program, all these accounts may not even be necessary to achieve the same results. Keeping a close eye on key metrics and making sure your books are updated daily will allow you to view your spending with the same speed as checking a bank balance, while also consolidating all those accounts.
Some Basic Accounting Terms
Once you have your business account(s) set up, the name of the game becomes managing your finances. You’ll need to decide on accounting method to use and, depending on your needs, enlist some help.
Accrual vs. Cash Accounting
The majority of small businesses run on cash basis accounting. That said, accrual basis accounting is the standard among larger, established businesses. Some businesses that hit a revenue threshold are also required to use it. So what’s the difference? It all has to do with when money is recognized by the company.
Cash accounting recognizes income and expenses when money changes hands. If you send out an invoice and a customer takes 30 days to pay, that money would be recognized when the payment shows up in your account.
Accrual accounting, on the other hand, recognizes money when it’s incurred. Meaning, if your customer takes 30 days to pay, your business will recognize that income on day 1. Accrual accounting gives businesses a better look into their finances over the long run, but it makes visualizing your business’ cash flow more challenging. For example, if you want to increase your advertising spend, accrual accounting may make it appear as though you’ve got more money at your disposal than you really have in the bank. That money is forthcoming, but you may not have received it all yet.
Bookkeeper vs. Accountant
To help you with things like deciding which accounting method to use or making estimated tax payments, you’ll want to rely on an accountant you trust. You may also want the help of a bookkeeper for day-to-day maintenance of your books. When it comes to managing your books, bookkeepers and accountants perform very different roles, but they’re often confused.
Bookkeeping deals with recording and classifying transactional information. Accounting, on the other hand, takes that transactional data and uses it to run financial reports, create financial models, and prep for taxes. Without accurate bookkeeping, accountants can’t properly do their job.
While accountants can perform a more advisory role than bookkeepers, they’re rarely the right-hand-men business owners are looking for. They can help quite a bit with understanding taxes, deciding on an entity type, and making sure your business stays compliant with the IRS. But for a more strategic partner, you’d likely need to look to a CFO.
Whatever your business needs are, be sure to communicate them with anyone you engage to help you with your finances. They’ll let you know if they’re outside their normal scope of work.
Go Digital as Much as Possible
Foregoing a bookkeeper or an accountant altogether may be possible with a digital solution like ScaleFactor that uses technology to make bookkeeping and accounting work quick and easy. But no matter what you decide, using digital tools to help you manage this work yourself or to communicate with your bookkeeper or accountant will speed up the process.
Law firms have done away with keeping boxes and boxes of documentation. The same should go for receipts. Come tax time, if you are searching through a filing cabinet for a missing receipt, you’re wasting valuable time. Instead, snap photos of your receipts as you go. If your accounting file allows you to attach photos directly to transactions, do so and include any other useful information you need to classify the expense. If not, even uploading photographs to Google Drive and keeping them in organized folders can be a big time saver.
The end goal? If your accountant has questions at tax time, you want to be able to quickly reference your receipts and answer their questions.
Important Metrics to Track
Last but not least, once your business is up and running, check back on your finances often to see how things are going. Use those clean books and financial reports to guide your decision making. It takes business owners time to discover which metrics matter most to their business, but here are some that are particularly valuable for newly founded law firms.
Cash Flow Statement
For new businesses, cash is king. You’re still building your client list, while also incurring a lot of expenses. A simple cash flow statement can help you analyze your cash-in and cash-out. The cash flow statement takes into account your operating activities, investing activities, and financing activities over a period of time to show you your overall cash balance.
If you’ve put some of your own money into the business to get started, metrics like cash burn rate and cash runway can give you a better idea of how long that initial investment will last you at your current revenue rates.
Profit & Loss Statement (P&L)
Also known as the income statement, a P&L shows net income or loss over a set period of time. It lists revenue, cost of goods sold, and operating expenses in order to show how much money was ultimately made or lost over that time period. If profit is non-negotiable for your law firm, then the P&L report needs to be, too.
Days Sales Outstanding (DSO)
DSO shows the average number of days it takes to collect on a payment. If you’re invoicing your clients on 90-day terms, you’ll use this calculation to learn how quickly (or slowly) your clients are paying you. If your DSO is much higher than the terms you set, it’s worth looking into your invoicing practices to see what you can do to encourage payment. Likewise, this number plays an important role in forecasting your cash flow. Knowing your DSO will help you better anticipate when cash will actually enter your business so you can plan accordingly.
Managing your firm’s finances doesn’t need to be a dreaded activity or even one that detracts from your real work. Make a practice of staying up-to-date on daily transactions and checking key reports on a regular basis and you’ll run your firm with the expertise of an M.B.A.—and a J.D.
Senior Tax Accountant