Top Pitfalls of Incorrectly Tracking Client Costs and How to Avoid Them

What is so tricky about client costs?  Most law firms deal with client costs on a regular basis and may not have stopped to consider whether they are tracking and reconciling their client costs correctly.

The Internal Revenue Service (IRS) is aware that client costs in a law firm are a different animal when compared to other industries. In light of this, the IRS developed the “Attorneys Audit Technique Guide” to train their auditors on the unique aspects of law firms. Within the publication, there is an entire section devoted specifically to client costs.

Before we can dig into how to avoid the pitfalls of incorrectly tracking client costs, we first need to understand the definition of client costs in the law industry.

There are 2 types of client costs:

1. Hard Costs or Advanced Client Costs – These are reimbursable client costs that can be directly attributed to the case or matter. Hard costs are essentially a passthrough item, as the firm may front the costs when receive an invoice from a vendor, and then pass the cost on directly to the client. (Note: sometimes the firm may not pay the vendor until they receive payment from the client; those would still be considered hard costs).

Examples of hard costs include:

• Deposition fees
• Witness fees
• Filing fees
• Travel expenses
• Medical records

2. Soft Costs – These are costs for office-type expenses that the firm incurs related to the case or matter.

Examples of soft costs include:

• Photocopy expenses (in-house)
• Postage expenses (in-house prepaid postage meter)
• Word processing fees

Now that we understand the definition of both hard costs and soft costs, we can dig into the top pitfalls of incorrectly tracking client costs and how to avoid those pitfalls.

1. Lack of knowledge – If errors are found during an IRS audit, ignorance is not an excuse for incorrectly tracking client costs.

How to Avoid it – Make sure to spend the time to download and read the “Attorneys Audit Technique Guide,” to understand how your firm is currently recording and tracking client costs on your financial statements, and also talk to your firm’s CPA to ensure you’re tracking client costs correctly.

2. Untrained Staff – If your staff isn’t properly trained on how to correctly enter client costs in the firm’s accounting and billing software, you run the risk of material mistakes on your financial statements, which could result in the IRS assessing penalties and interest as a result of an audit.

How to Avoid it – Once you have addressed the lack of knowledge pitfall, make sure your staff is adequately trained to comply with how costs should be tracked. Provide them with processes or manuals to explain how both hard costs and soft costs should be entered and tracked in your firm’s accounting software.   

3. Inadequate Accounting & Billing Software – Ideally, you want to have sophisticated software that makes entering and tracking client costs easier, not harder.

The best software for law firms has safeguards in place to help with entering, tracking, and reconciling client costs. If your firm is utilizing multiple applications for accounting versus billing, it is more likely that your client costs on the financial statements are not going to match what is in your billing software/client ledgers. If the financial statements do not match the client ledgers, this is another risk that could result in the IRS assessing penalties and interest.

How to Avoid it – Consider investing in software that is designed to track and reconcile those client costs on the ledger with the financial statements.

4. Deducting hard costs as an expense – Some firms may not be aware that even if they are operating on a cash basis for tax purposes, they should be tracking hard costs on the firm’s balance sheet.

According to the Attorneys Audit Technique Guide, “Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement.” The only time hard costs should be recorded on your firm’s income statement is if those costs become uncollectible, then they should be written off in the year they are determined to be uncollectible.

How to Avoid it – Identify all expenses that are defined as hard costs. Once that has been completed, make sure all hard costs are mapped or setup in your accounting/billing software so that any hard costs incurred, billed, or collected are flowing through the balance sheet, rather than the income statement.

5. Not recording income for soft costs – If your firm is operating on a cash basis for tax purposes, then soft costs should be recorded as income when paid by the client.

According to the Attorneys Audit Technique Guide, “Attorneys on the cash method of accounting are generally allowed a current deduction for client reimbursed costs which are allocated to normal operating expenses, (for example, secretarial costs or copying costs). These are general office type expenses which would reasonably be incurred even if not charged to a particular client.”

As the firm will have recognized the expense on the income statement, such as the costs of paper or ink for the photocopy machine, when soft costs are paid by the client, the firm should record those as income (or an offset to the original expense account).

How to Avoid it – Identify all expenses that are defined as soft costs. Make sure all soft costs are mapped or setup in your accounting/billing software so that receipts from clients for those soft costs are recorded on the income statement. Note that your firm may choose to have separate income accounts for soft costs, or you may offset the original expense account to reduce the firm’s expense on the income statement.

6. Not reconciling your client costs – Client costs should be reconciled monthly. If not, you run the risk of entering incorrect balances on your financial statements.

You should know or be able to generate a report for any point in time that will provide the costs incurred but not yet billed (work-in-process), costs billed to clients but not yet received (accounts receivable), and the amounts owed to vendors for those client costs (accounts payable).

The amounts on the client ledgers need to agree with your financial statements (as hard costs should be accrued on the balance statement), as stated in the IRS’ Attorneys Audit Technique Guide.

How to Avoid it – Make sure your firm is closing accounting periods and reconciling the financial statements every month. Know which reports should be run and how to identify and fix any discrepancies that you may find.

So now that you know the top pitfalls of incorrectly tracking client costs and how to avoid them, what now?

• Find out if your firm is tracking client costs correctly, and if not, contact your firm’s CPA as soon as possible. If hard costs are not being accrued correctly on the balance sheet, your firm may need to file Form 3115, Application for Change in Accounting Method.
• Take the time to evaluate your firm’s current applications being used for accounting and billing. Find out if there are items within the software to make tracking client costs easier to reconcile and safeguards in place to help prevent errors.

It is always going to be in the firm’s best interest to find and correct any problems before an IRS auditor does. If you wait for the IRS to step in, having the IRS calculate penalties, interest, and adjustments for prior year mistakes can become very costly for the firm.

This blog post was originally published on March 23, 2021.

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