The uLaw Introduction to Bookkeeping

Due to the nature of the services lawyers and paralegals provide to the general public, special obligations are placed on legal practitioners in Canada in order to remain in compliance with federal and provincial regulators.

The collection of tax and reporting of income is regulated at a federal level. As with any business in Canada, companies (law firms) and individuals (sole proprietors) are expected to produce accurate and up to date financial information about their enterprise to the Canada Revenue Agency (CRA).

Provincially, law practice providers are also obligated to report additional financial and practice-related information about their firm to Law Societies, which have long been entrusted by legislatures to regulate the legal profession. Since before Canada became a country, representatives of government, to varying degrees, relied on self-regulated groups of legal practitioners to maintain public trust of the legal profession.

In an effort to combat corruption and ensure integrity, each province’s Law Society has a vigorous framework established to ensure legal practitioners are accountable to the people they serve.

As is often the case for lawyers (and, increasingly, paralegals) acting on behalf of a client, money is held in trust and disbursed during the course of a legal matter. Various internally produced journals, books and ledgers must be congruent with the flow of funds from one account to the next. The same data generated by these documents must also be corroborated with meticulously collected source documents, which often take the form of bank statements and deposit slips.

One particular advantage to the strict reporting obligations for Canadian legal practitioners is the byproduct it creates for law firms. The data produced by these compliance documents can serve as useful tools when making decisions about how to run their practice.

Throughout the course of this book, readers will come to understand not only what’s required of Canadian legal practitioners as it relates to bookkeeping and audit preparation, but also how managing their books and records can keep a firm aware of how it is doing financially.

Accounting systems explained

Law Societies across Canada have long been educating licensees  about the different styles of accounting available, because their auditors are the ones responsible for mulling over all the financial data every time a spot audit is conducted on a firm.

Today there are roughly five different types of legal bookkeeping styles currently used by law firms. Depending on where a firm is placed in its life cycle (i.e. just starting out vs. a more established, multi-partner law firm) can be a factor in determining which method is most suitable.

Manual double entry

Manual double entry bookkeeping is a tried and true, paper-and-pencil method of accounting that has been used for centuries. According to historical records, the first evidence of manual double entry was found during the Goryeo Dynasty in pre-modern Korea between 918-1392 C.E.

To this day, some lawyers continue to use manual double entry due to its simplicity, but also as a force of habit. Sole practitioners with decades of experience working for themselves may find it difficult to see any reason to change the manner in which they handle their accounting: with the use of a simple, single-margin notebook.

One of the advantages to manual double entry is that, at its core, the system is very straightforward and inexpensive. Each time a transaction occurs, it is recorded and accounted for in at least two places. Using this method provides self-checking accuracy while also creating an adequate audit trail--both of which are important when running a business of any kind.

Double entry bookkeeping works by recording both debits and credits captured during the accounting of a firm’s financial activities. More information on debits and credits will be provided in unit 1.4

When a single transaction takes place, a manual double entry system will record the movement of money in two instances: once on the left-hand side of the accounting equation, and another on the right-hand side. In this way, the system acts as a check and balance against the flow of money within an account.

There is one notable downside to this style of accounting. It is the potential for human error to take place and remain undetected, sometimes for years at a time. This is because manual double entry heavily relies on whomever is filling out the information and performing the arithmetic tasks necessary to properly account for transactions taking place within the firm. Another downside to manual double entry accounting for lawyers and paralegals is that this method can also be time consuming, especially if a firm has a large number of transactions to record.

One write

Also known as single-entry accounting, this method captures data using only a single logbook. This method is often perceived as being simpler because it doesn’t require data to be inputted twice, as it is with double-entry.

To properly use this method of bookkeeping, users must be sure to delineate between revenues and expenses. See the table below for examples of both three and five column one-write accounting logbooks.

Sole practitioners who are first starting out may opt to use either manual double entry or one-write accounting styles because the number of transactions taking place may be small enough to handle with the simple logbook approach. As a firm matures, practitioners may increasingly see the advantages of more sophisticated bookkeeping solutions. This is all the more pertinent once a lawyer starts accepting retainers and managing  trust accounts.

Once a firm begins to conduct higher volumes of transactions, a one-write system can become cumbersome. A more complex solution may be necessary. Also, similar to manual double entry, another disadvantage to the one-write system is that undetected arithmetic errors may arise.

Spreadsheet software

Another accounting system used by Canadian practitioners is spreadsheet software.

Widespread computer usage since the 1990s has solidified spreadsheet software as an industry standard for bookkeeping in virtually all industries. Now more than ever, companies have a wide array of software options available for producing spreadsheets. Some are free and work as a “software-as-a-service’: meaning they no longer require individual files to be stored on a device’s hard-drive.

One large advantage of spreadsheet software is that it can automatically perform arithmetic tasks. Improper or mistaken usage of formulae and data entry into incorrect spreadsheet cells however, can create problems which may be hard to detect. This leads bookkeepers down the unfortunate route of pouring over months of financial data to find the source of a bookkeeping error. Depending on the situation, some bookkeepers might not even notice these problems until they get audited.

General Accounting Software

Spreadsheet software may be the de-facto manner of handling books and records for most businesses. A whole industry of software providers, however, have risen up to provide general accounting software to further assist the work of a bookkeeper.

General accounting software makes automatic calculations and posts data to sub-ledgers. Overall, this method far outperforms older styles of bookkeeping. As one may expect, this style of bookkeeping is more expensive. Nevertheless many private businesses, large and small, make regular use of general accounting software for their needs.

When using general accounting software, time consuming activities such as creating financial reports can be done on the fly with the use of programming. For lawyers, some risks may be presented with the use of general accounting software. The reports generated with the use of general accounting software are not designed for legal practitioners in mind. As a result, support for trust accounting procedures is spotty at best.

If a law firm is dealing with trust accounting, it might be a good idea to plan a proper bookkeeping and accounting solution to take into account the numerous types of financial reports which must be generated to remain in compliance with the law society. General accounting software does not adequately prepare these reports to fulfil the requirement of auditors.

Legal Accounting Software

This is the gold standard of legal bookkeeping, and it’s a method that is well known by Law Societies as being superior in its delivery of the basics of accounting as well as some of the more advanced bookkeeping requirements to be a practitioner throughout Canada’s provinces and territories.

Since legal accounting software is specifically geared for the needs of law firms, many forms and reports are easily generated while also utilizing data that has already been inputted into the system. Using this method is the fastest and most efficient way to prepare a firm for optimal financial compliance with regulators, as evidenced by its glowing recommendation in internal law society literature (for LSO bookkeeping guidelines for lawyers and paralegals see ‘types of accounting systems’).

One notable downside to legal accounting software is that it does require some training before its users can make full use of the system.

Chart of accounts

From large to small, business entities often rely on different accounts to ensure money is flowing in the right direction. Hoteliers, bar owners, banks and plumbers can reasonably be expected to have vastly different types of accounts due to the variation in their business models. Nevertheless, from the perspective of an accountant, there are a lot of similarities among businesses in terms of the types, or categories, of accounts being used. This is why several different subdivided categories are routinely used in the production of a chart of accounts (COA).

A COA is a list used to define each class of item or account where money is spent or received in an organization or business entity. The following five categories are routinely used in a chart of accounts for many businesses:

1. Expenditures
2. Revenue
3. Assets
4. Liabilities
5. Capital

A COA segregates the above components of a business so that it is easier to scrutinize its finances. It’s a detailed chart which creates a unique identification number for each individual account used by the business. Each of the above five categories will have individual accounts listed beneath it but will also contain a number range (100-199, for example) in order to make it easier to locate. In this way, a chart of accounts is the accounting equivalent of a table of contents because it acts as an organizational tool for the business.

Chart of accounts for Canadian Legal Practitioners

While there are many similarities across different legal entities (businesses, non-profits, organizations and government agencies), Canadian law firms do have a few marked differences when it comes to how their chart of accounts looks in comparison to other entities.

Many lawyers collect retainers and thus are holding money in trust. While this arrangement is considered an asset to the bank once the money flows into the firm, it’s also a liability for the lawyer because it’s not their property.

Proper accounting for revenue is complicated for legal practitioners in comparison to other businesses. Depending on their area of practice, a lawyer’s books can vary wildly. And unlike many other businesses, expenses actually generate revenue for a law firm.

Debits and credits explained

The windows are rolled down, and the coffee is almost in the cup holder. It’s an early, icey morning and a dozen vehicles are idling in a drive-thru routinely visited by commuters making their way to work.

‘Debit or credit?” asks the early morning drive-thru attendant. She’ll repeat that word all day, as most Canadians prefer to use either their bank-issued credit cards or debit cards to make purchases, instead of cash.

Well into the 21st Century, with most consumers reaching for the ‘tap’ function, many would be surprised to learn that the words ‘debit’ and ‘credit’ are actually a lot more different (or even the opposite) to what they thought.

That’s because the origin of the two terms finds its meaning in the dual nature of financial transactions.

Debits and credits: two sides to the same coin

Although it could be viewed as a single activity, the purchase of an item (such as a cup of coffee) is actually two events transpiring simultaneously. The same can be said for any transaction.

In finance, money doesn't just appear or disappear into an account. Drawing from the coffee example above, the only way a shop owner can obtain money for the product it is offering is if the same money has left a customer’s account. Debits represent the flow of economic benefit to a destination whereas credits are the opposite. A credit represents the flow of economic benefit to a source.

Recall earlier in the chapter (1.2), on bookkeeping styles. Double-entry accounting has long been the standard for accountants to create proper checks and balances on the accounts they are managing. Double-entry bookkeeping records every transaction twice, which means it too relies on debits and credits.

Rules of debits and credits

Since each transaction must be recorded twice, an entry on the left column of a general journal is debit (Dr.), and an entry on the right-hand side is always credit (Cr.). The total of each side is equal to one another. A debit entry in one account is always offset by a credit entry in another. Balanced books will always have debits and credits that are equal to one another.

The assets side of a balance sheet is the debit side. An owner’s equity and liabilities is the right side of the equation. This will be described in greater detail later in the chapter.

Debits and credits: a banker’s perspective

One of the most confusing elements of understanding debits and credits for many is that from the perspective of a bank, it may seem to be in reverse. This is because for every deposit made to the bank, the bank views this as a liability because it’s not their money--it’s yours!

This is why, when your firm receives a statement from the bank, deposits appear to be a credit. They owe you the money, and thus it is reflected as such by the bank when it sends statements to customers.

If you write a $750 cheque against your general bank account, you need to credit the general account because you’ve lowered the balance, which is an asset.

Opening Balance

When a law firm first sets up its books, the numbers from an opening balance sheet will be recorded into the firm’s general journal. Afterward, the entry made in the journal is then transferred over to the general ledger, acting as opening entries.

At the beginning of each accounting period, the total balance for each account is what is referred to as the opening balance. This number is taken from the closing balance of the same account from the end of the last period.

The Accounting Equation

Recall earlier in the chapter, debits and credits were explained as they pertain to the double entry bookkeeping system. Below is the accounting equation.

Assets = Liabilities + Owner’s Equity

Any transactions made through the business are analyzed using this basic equation, which can be expanded upon for various purposes.  So let’s have a look at the three main components of this equation in further detail:

Assets are resources owned by a business or a person. An asset can represent an object or collection of objects, tangible or intangible, which hold a value and benefit the firm’s operations. Assets are typically broken down into two different groups: current assets, and fixed assets. Current assets are cash or assets that are expected to be converted into cash and expended within a year. Fixed assets are longer-lasting resources which hold value. Assets are not always owned outright by a firm, or at least not right away. Oftentimes assets are bought on credit, which leads us to another critical term of the accounting equation.

Liabilities are debts owed. Loans, accounts payable, and all items purchased on credit (whether they be supplies or assets) are considered to be liabilities. In the event a firm wants to close, it is required that all liabilities be paid out before any leftover money can be collected by a business owner.

Owner’s equity represents the remaining value of assets once all debts owing (liabilities) are deducted. Various types of equity exist, but most often it is referred to as shareholder equity, which represents the amount of money that would be given to shareholders if all assets were liquidated in addition to all debts being paid off.

Equity represents the actual ownership of an asset once debts are subtracted from those assets. In keeping true with the accounting equation in fig[PLACEHOLDER]

Assets - Liabilities = Equity

Understanding Income & Expense Categories

In addition to assets, liabilities and owner’s equity, income and expense categories are also important to understand.

Income - In law offices, the main source of income is fees billed out to clients. When fees are billed out to clients, they’re immediately referred to as income despite the time it may take to actually get paid. Other sources of income can also be through the recovery of expenses or interest income.

Expenses - Any cost incurred by a firm, if it is in the pursuit of earning money, can reasonably be classified as an expense. Advertising, the costs of operations, transportation and vehicle expenses, interest, rent, wages, dues, subscription and licensing fees, utilities and phone bills, are all different types of expenses.

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