Advanced Client Costs

Welcome to Accountants LawPod, where accounting professionals and law firms converge. Hosted by Lynda Artesani, Sarah Prevost, and Stephen Libhardt.

Welcome back, everyone. It is Steve and I this week. Lynda is traveling and—

Hi, everybody.

Hi. She'll be joining us next week or later this week. We're doing our first ever company retreat, so it should be fun. But hi, Steve, how are you?

I'm good, how are you, Sarah?

Doing all right.

Good.

Full moon this last weekend and it sure—

Yeah, you just mentioned that before the recording and I was like, no wonder I've been so melancholy and moody this weekend.

I think it just hit my pocketbook. My dishwasher stopped working, all that funny stuff happened, but whatever. It is what it is. Costs. It's costs, Steve.

It's costs. Yeah, we have advanced client costs in our homes, don't we?

We do. Yeah. Our topic today is advanced client costs, and boy, did I pay for some this weekend in that realm. So we should kick it off with what is advanced client cost and what are the rules, the details? The IRS information that goes, that governs it as well.

Good plan.

So, I mean, I think Steve, you do this well in your instructional at the bar when you do a lot of teaching in your area, you probably highlight the different rules subjected to advanced client costs when it comes to hard costs and then otherwise known as soft costs as well. So do you have any tips that you like to kick us off with or thoughts?

Yeah, you know, when I first worked in law firms, my mentor was, uh, an attorney who was also a CPA and an IRS enrolled agent, and I never understood why he insisted on having advanced client cost as a miscellaneous expense on the P&L. And for years and years we argued about it. And when I went out into my own realm many years ago to, to support law firms with it, I really dove into advanced client costs. And ever since then have, you know, moved it to the proper way, which is over on the balance sheet. And the reason is, for those of you out there that are confused about what is an advanced client cost and how to handle it, it is— Boil it all down, it is nothing more than a loan to your clients. That's what it is. You're loaning somebody money, and that's an asset to you, and it should be listed as an asset on your balance sheet and broken down by client. Name, client account number, whatever you use in your billing system. And to me, it's a lot like the 3-way trust reconciliation. You reconcile your billing software against your advanced client costs and also a category in that asset ledger of ones that you know you're never going to be reimbursed for. And call that unreimbursable client costs, for lack of better words.

Yeah.

And throw that in there because that's going to help your tax preparer, which we'll talk about. Later on in this podcast today. That's going to help them when at tax time to help capture anything they can for you when they're preparing taxes. So now I've given you this really long answer for tip number 1. What's your response to that, Sarah?

I simply—

Go!

I simply make it an advanced client cost is just that. You're advancing costs on behalf of the client for future billing to recoup it. That's what you're doing. And a lot of those fall into hard and soft costs. Soft costs now, mind you, are those soft, like photocopying, postage. So maybe you've simplified your billing method, and you've established in your engagement letter that there's what is often considered like an administrative cost fee, where you're not going to track every little nickel and dime unless it's over a certain amount, which obviously there's a lot that goes on with that in law firms, because you're You know, you got your copy machine, you got your postage. I mean, you're not— there's a lot of time spent.

Some of them call it administrative fees and it's a flat rate.

It's a flat rate and it just helps absorb because you can really figure out how much mailings you're going to do. You're— there is a way for you to kind of figure that piece out. And it's also administrative expenses, legal research. Sometimes we're all paying subscriptions for a legal platform to do the research for the case. That's not an individual cost basis. The hard costs are representation, witnesses, um, those type of media—

Legal filing fees.

Legal filing fees, serving, um, those types of things. Sometimes parking, honestly, depending on what your court case is doing. So those are costs that you're incurring in advance of the case that you're going to have to pass on to the client. And it's just a pass on, it's nothing— you don't mark that stuff up. That's not where you do that. That's not allowed, really. You— what you do is you track your legal services separate from that. So I keep it simple and I talk about it in that way. What I often see, Steve, is not everyone follows the method that you brought up, which is we're going to advance— put it on our balance sheet. Not every tax person sees it that way, and not every law firm.

You're right. Yeah.

So when that moment arises, it's good to identify, and it sounds interesting for us accounting people asking this question, how do you identify it? What does your engagement of services say for your clients? We're only asking so that we can determine the best method to ensure that you're getting it right on the calendar year tax year correctly. You're not overstating, understating it, right?

And consult with the tax preparer as well, with the CPA. Yeah. And say, you know, how do you, how do you want this handled on this client's books? Because, you know, different types, different practices of law, they may want to track it differently, you know.

So true, because obviously when you're in a contingency style, there's a lot of costs, upfront costs that you're paying for that you really have to track. That bingo.

I mean, you had—

It's totally different.

Yeah. Great example. Great example.

Well, isn't real estate too transactional pieces like that? That's another one, right?

It's another one that's very similar. Exactly. And you need to know what, you need to check and see what the requirements are in your state, in your jurisdiction.

True. That's true too, Steve. You always bring in those good tips. Now, I do think— I, I don't want to say it's end-all be-all, and you have to do it one way or the other. It's adopting a hybrid method, is what I call it, of what's, what's sustainable. The biggest thing that I've seen, if you're not in— if you don't have our knowledge and our background, and you don't have our expertise, I've seen where it's not done correctly, and it's a costly mistake. On the books coming from the accounting side, but also on just us understanding. So what's considered— because it's not income, but it needs to be separated on your profit and loss of legal fees versus billable expense income. And what I often refer to, similar to what you said, um, a little bit, there's client expense incurred. So those are when you're incurring it, and You know, some people really like a lot of detail in there, but you said it best, Steve. You have a billing software that keeps track of that. Rely on that data. This is just a way for us to summarize it to ensure where are the numbers lining up, how accurate are those numbers. And then from there, there's also client expense reimbursement too that we didn't talk about where clients have paid for costs. That are also part of the case that need to be recouped back to them.

Oh yeah, yeah.

And then you have to decide on that hybrid method. How is it going to work? Is it all going to get booked in one way at the end of the year? Do you make an adjustment entry? What are the supporting information for that? And to your point, Steve, you have to talk to that tax person too, and the business owner, the law firm owner, just to ensure that we're all on the same page with how this method is working and it's not a big surprise. 'Cause it's been a big surprise for a lot of clients.

It has, and it's so crucially important, excuse me, to—

Important.

It's important. It's important to get the receipts. Keep those receipts and attach them to your, as an example, to your bookkeeping software, to the transactions in the software. Because when a case is settled, we'll use the personal injury or certain real estate type transactions. When the case is settled or the transaction is completed, some, you know, quite often you have to provide an accounting of that to a court, to a— especially in personal injury, you know, when, when, um, a decision comes down from the court and says, you know, you get this much, or a settlement happens and then you're negotiating the settlement and who gets what, you know. It's very important to have all those receipts.

Probate is huge. I mean, that's a big one.

Exactly.

Um, lien, lienholders— we often see this where it's closed and then the lien will come, like Well, that's, that's, it's hard. And I think it feels intrusive when we're asking what does the engagement of services look like so we can understand. It's only for us to understand where things really need to map out on those books for accounting purposes to support whether you're sustaining a law firm where it's at or growth or whatever it is that you're doing.

Well, we're only trying to protect you as a law firm. When we ask that question.

Yeah, exactly. So IRS has key requirements that they, they list and, and you all can, you know, go to the IRS rules and read them. They're super fun. And it talks about what you said earlier, Steve, that it is a record of an asset. It's a receivable. It's not an expense until it's reimbursed or written off. And there's rules around write-off. Which, Steve, do you want to talk about what that is a little bit?

I don't know the rules specifically, but a lot of— I've run into lots of conversations with various tax preparers on wanting us, with many different clients, wanting us to keep a ledger of unrecoverable client costs. And at the end of the year, tying that back to the billing software and seeing if there's any loopholes that have been missed. And determining with the involvement of the client, of course, the law firm itself, what they are not going to recover. Um, because that affects cash flow, you know, that if you have a high receivable out there or an asset ledger with a lot of cost receivable on it going into year-end, you really need to look at that. So, um, the tax preparer then determines what you— how much you can take based on the IRS rules. To your point of reading the IRS regulations, you know, we don't We don't specialize in that.

We don't specialize in it. It's our guidance, what we understand. We can read it like a business owner. We can read it, but ultimately we will have to defer because it's not our specialty. So we're not licensed for that. But there are, you know, it's determining what's uncollectible and what's considered write-off. Or like you said, we have to basically— that expense is incurred, but we can't— it's not recoverable and we need guidance for what's allowed and what's not allowed because there's other guidance around that. But we, we operate, I think, with the best of intentions of we understand the, the general sense of the guidance of it and that we will operate in that method with a lot of documented notes is what you're saying, Steve. We put a lot of information into it.

Correct.

And we try to line it up so that things aren't misclassified and inflating or uninflating areas on your financial reports.

Well, you know, sometimes there's the situation where there's a huge balance in a particular case's cost receivables that requires a line of credit and a loan. Yeah, to, you know, let's talk about that. You've probably had more experience than I have with that, but we've talked about it briefly in other recordings and things. So, you know, what, what does that look like?

So unfortunately, if You have to really have the right person in the right seat. I've seen this happen. I've seen the DIY moment where I've gotten a loan. Guess what? Guess where you put that loan? You counted it as income because it was a money— it was money coming in. You didn't know how to record it correctly.

Ah.

So that's a problem. I think for best practices in these situations for tracking and managing client costs— and advances on your own credit line. You have to be prepared, depending on your practice area, you have to be prepared for what you're going to incur. Um, and you have to get your billing just right too. There's going to have to be things that you do, um, based on your practice area of how you do your billing so that you can support, um, what that looks like. We've seen a hybrid of different things. We've seen people charge interest on when they've had to advance. We've seen them go out to a product that charges interest that then gets push back onto the client. Makes sense. These are all advances. They're temporary loans, to your point, Steve. So separating out how you record these types of expenses, hard or soft, making sure that you have good intervals for billing and/or tracking methods in your billing platform to ensure that you, you balance, you have all the expenses prior to the close of the, the case, and then, um, you leveraging honestly the technology that you have. We always see this. There's always a side spreadsheet. There is absolutely nothing wrong with that. If that makes it— gives you a second pair of eyes of due diligence, do it. There's nothing wrong with it. What I often see as a problem, Steve, is people get what I call batch payables. Mm-hmm. So let's say you have mediation arbitration investigators and they're sending you a bill for multiples. How, how is that getting booked in appropriately and balanced back to what you've paid that vendor?

The first thing that comes to mind when you said the word arbitration, so it's already out being negotiated to try to get people to settle.

Yeah.

I think that you need to have internal controls in place for those situations, and that you have to have pre-approval requirement for larger unusual costs in those scenarios. You know, the, the run-of-the-mill, um, flat administrative fee or the soft costs for postage, however you want to track it, all those sorts of things are just that. But in very unusual cases where you're, you're reaching a mediation, or perhaps you're a personal injury firm and you're negotiating a settlement, you need to have internal controls for preapproval of those large and unusual costs. And I'm saying this to the attorneys out there because your paralegals and your staff are just like, we're going to push this through, we're going to get on to the next thing and so on, and we'll let accounting deal with it later. You need to know about that, Mr. and/or Ms. Attorney.

Mm-hmm.

You need to know about that unusual or large cost. You should be on top of your cost receivable ledger. And to my point earlier in this podcast, of reconciling against the billing software. That's where those anomalies will show themselves. And you need to set a threshold for staff approvals as part of your internal controls. And you need to reconcile that ledger before you pay one penny out.

Reconcile that ledger. I love this. I love this tip because let's say, for example, a case is happening and there's cost overrun. But really, you have that budget and it happens. But wouldn't it feel better to engage the client to say, look, due to the way this is happening, there's additional costs rather than just presenting it and it is what it is. So I think it's a great idea. I've never thought through it in that lens. But because you've worked in the spaces at that and you teach to it in a different way, I think we have a good balance between each other.

We do.

We do.

And I've seen it, I will, I mean, I should say I've seen it on the other side, on the account, when you say like it goes to accounting, they'll deal with it. I've seen it on that side and it's not fun.

No, it's not. Surprises should not happen. Too late. It's too late. I've seen law firms get burned out of several thousand dollars to your point when, well, let's say something comes in from Medicare that's, or from a, you know, in the settlement or whatever, you know, or in the real estate transaction when, some sort of housing authority comes up with a last-minute cost and all that, you know, and they could, they can add up. And if you didn't know about it, sometimes the firm has to eat that because the transaction is closed, it's over, signed, sealed, and done.

Yeah.

And then they eat it. And I hate to see that happen.

Yeah. I mean, I understand the logic behind it 'cause it's too late and it should have been, yeah, it's a double-edged sword sometimes. But overall, I do feel like You, like you just said it best, it might be role user permissions based on vendor criteria, based on, you know, the case, the management of the case. And there's a lot of hands in the pot that go across this. You've got the attorney kind of, you know, out there collecting what these potential fees would be. Where does that get shared? How does that get managed? Where does a paralegal be able to support that and understand what that is? Or when an extra cost walks in the door, why? Kind of thing.

Here's another angle to what you're saying, and this one really hits home. There are those firms where you get paid on, you eat what you kill scenario.

Yeah.

Where, you know, the attorney gets paid based on their production. And I've seen it. I've seen it where a large cost comes in later that they knew about, but they didn't account for. And when it comes in the door, that attorney gets dinged for that on their pay or their bonus structure or whatever. And then, you know, they squawk like crazy over it. And it's like, well, dude, you knew that was coming in. Mm-hmm.

Which goes back to, I think, one of our conversations, and we'll probably highlight this in a different episode, about billing software in general and making sure what types of platforms you use to support this inbound dialogue. Absolutely. It's hard to keep track. Emails are unfairly the way to do it, only in the sense of we know how it feels. You've got a thread that turns into another thread, but it's still on the same thread. It has no reference and it's natural. I'm not pointing fingers nor judgment.

It happens. You're talking about my pet peeve though, and I parse those emails out, especially when they've got lots of numbers going in. I'm like, okay. And I tell everybody I'm parsing this out into a separate conversation. After a while, and we're kind of going down a side trail here, But after a while they'll get used to me being a pain in the tail end because I absolutely detest those kinds of emails and that's where things get missed.

Well, I guess it's a—

it's—

it kind of goes into the best practice common mistakes and pitfalls. I think in that scenario it's looping in something else, but it really brings it back. I mean, as it is, there's enough stuff happening in a firm It's not— it's unfair to expect everything to rest on one person or one team's shoulders. It's a collaborative effort.

Bingo.

And when we, I think, learn the language and how the firm works, it's where we can— and that takes a little bit. That is not a— just because we're experienced in our area, it's not a light switch moment. There's communication differences, there's style differences, and we want to make sure we're enhancing or tailoring how to make it not so much improve it to improve it, just how to make it fit so we can understand. And I think, Steve, when you're probably doing this for newbies, it's really hard for a newbie to even understand, like, what do you mean I have to document all of this and then somebody else is going to take it on? That's not what I opened my doors for. And some people know right away, I open my doors with partnerships. I know what I'm doing and this is how we're going to do it. Whether it's good or bad, I don't know, but I'm sure you've probably navigated a lot of these questions on those newbie classes.

Sure, sure. I'll give you a great example for newbies. Let's use Amazon as the example. And so the attorney goes out and— and newbies means newbie attorneys, folks.

Yeah.

So new attorney goes out and wants to really look good at the arbitration table or in court or what have you, meeting with opposing counsel, whatever you're doing. And so they, you know, in the days they would buy all these binders and paperclips and, you know, all these things from Amazon. And Amazon would say, okay, well, this is $48.10. And then they would notify accounting or whatever their system was to put the $48.10 into cost receivable. And then, you know how Amazon changes. The number when they ship it. And lo and behold, they get audited by the arbitrator and it doesn't match and there's no receipt and it's, ah, turns into such a mess.

That—

and just that teeny tiny example can create waves through the entire process of the closing.

What about the places where you can, like Costco, where you can buy not just office supplies and bulk, but to your point You have to be really diligent about how you're—

Exactly, that's the word.

Separate these costs and have what's acceptable means, electronic photos and acceptable means of receipts. I mean, in other types of billing, in order for you to get reimbursed, you have to show the receipt that it's been paid and when it was paid in order for it to even be in your invoice to be reimbursed by some other corporation, let's say, that's going to pay that bill. So it's the same thing in this situation too. I— to your point, you'd have to have a copy of the costs. And where are those receipts? Someone's desk.

Yeah, exactly. Hopefully attached to the transaction in your billing software or your accounting software, you know.

Yeah, I agree. That's a really good example. I always think about those anomaly ones where it's like Amazon. You can buy a lot of things things from too. But, you know, a lot of people know Costco or Sam's Club or whatever it is in your regional area, and that can happen.

It does.

I think the biggest thing is the other lens that we, we danced around is what is the true cost of, of separate from the reimbursed expenses, the advanced client costs? What is the true cost that the firm's incurring? What are those losses? And how do we make sure that you're managing that well case by case? Because it's a domino effect, right?

It is a domino effect. And it can— if you don't account for it properly and you're down to the, the tail end of the whole thing, it can cause misunderstandings with the client who then, you know, starts to mistrust different things in the case and asking more questions. And it's like us in the accounting world. We do 99.99999% of everything is so accurate. And that one little 1/14 of an 1/8 of a percent error that is made and they question the whole set of books.

It's so true. Or, or I'm— I can— I, as an example, will inherit a set of books that was done from a non-legal accounting professional.

Good example.

And then we'll have to backtrack a bit. Well, it's crossed over multiple softwares, billing softwares, management softwares. Softwares as well as tracking methods. And some of the data is good, some of it's not great, some of it's been improperly earmarked because it was said that's where it goes. And then you realize, you pull it apart, that's— maybe it goes to another case. And that goes to your point, I, uh, Steve, which is the, the process and implementing the right roles and the right ways to do it, whether it's right now, correct today, the right way to do it. But at least it's a process that you can back up and you can look at. So—

Absolutely.

So much into this. Like, there's— we could probably go on for another hour.

Don't turn the accountants loose because we're going to talk about all this fun stuff. So—

You know what? It's similar to other industries, but it's different enough that you really, to your point, you really have to create due diligence because it is a front-facing, client-facing moment. So you have to know.

I look at— I like to compare things. I look at cost receivables like doing inventory for a business that— a manufacturing business. And you have to do inventory once a month. Same thing with cost receivable. What have you got there? How many How many cost receivables are in that bucket? And do they tie to what we've billed on the billing software? And if not, same thing in, you know, doing an inventory in a factory. You know, we have 1,400 widgets are supposed to be in this bin and there's only 1,300 there. Where did the other 1,000 go?

And then to your point, you're advancing yourself. You're taking a loan on the business to advance these costs. How is that all getting— like, how far out are you? Did we miss the billing? Um, should a case be closing? Where do we sit? I mean, those are all factors inside of this. So wow, I was not expecting to talk at this length on this particular one, but it is a true— it's a good one.

And that's why you have us people, us bean counters, folks.

I wish I had beans.

Yep. Well, great conversation. Thank you, Sarah.

Absolutely. Thank you.

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Awesome. Well, thank you, Steve. That was good.

Thank you, Sarah. So good to see you again.

Good to see you.

Bye-bye. Bye, everybody.