How should bookkeepers account for legal retainers? This is a question we are often asked and it is a good one. However, before answering it, let’s first dive into how a legal retainer works.
The way legal retainers work is when you first sign up with a lawyer. They will often ask you to put some money down, so they know you are serious about working with them and will pay your bills. Iit gives them a lot more comfort. They are going to work hard for you because they are confident that they will get paid. Note that we see a LOT of legal fees, and even have published a list of the top lawyers serving startups.
Typically, a legal retainer is around $10,000 to $20,000. When you go through a fundraising round as a startup, the bills get pretty high, so $10k, !20k is usually what the retainers range is.
How should the legal retainer be booked in your accounting system?
- Book the Retainer in Prepaid Expenses.
- As future invoices come in, there are two options:
- 1. Debit against the Retainer. If they debit against the Retainer, eventually, that Prepaid will be fully used up.
- 2. You’re charged monthly for your services and keep refilling the deposit.
- TIP: Get solid invoices from your Law Firm, including hours, work completed
The retainer is really like a deposit. When you make that type of deposit, you will secure it as a prepaid expense on the balance sheet. You don’t expense it because you haven’t benefited from those services since the lawyer hasn’t done the work.
You would expense it in cash accounting because that’s just really tracking cash going in and cash out. However, that is not how we do bookkeeping at Kruze Consulting. We do everything on an accrual basis, and your startup should as well. Our clients need GAAP financials.
It is going to get booked as a prepaid expense on a balance sheet. Once in a while, you’ll see it as a deposit, but really, the proper way of doing it is a prepaid expense. Then, as the lawyer starts working for you, they will send you an invoice every month.
There are two ways the lawyer will ask you to treat that invoice:
The first way, the super high trust. The lawyer believes in you and thinks they will not get stiffed just to reduce that retainer for the corresponding amount in the invoice.
Example: Say you have a $10,000 retainer, and the lawyer does $5,000 worth of work for you in a month. They then just reduce the outstanding retainer or prepaid expense by $5,000. So you are left with a $5,000 prepaid cost or retainer. Again, that is a kind of high trust. You know the lawyer, and they trust your type of situation.
Other lawyers value having that retainer buffer. So when they send you that $5,000 bill, they expect you to send them a check or electronic payment for that $5,000. They always want to retain that $10,000 buffer.
Answering specific questions:
Are legal retainers prepaid expenses?
Yes, a legal retainer can be considered a prepaid expense. A retainer is a fee paid to a lawyer or law firm in advance of services being rendered, and the law firm should hold it in a trust account until the services are provided. It gets booked to the balance sheet as a prepaid expense (which is an asset). As the billings occur against the prepaid asset, it is reduced and the billings are recognized/accounted for on the income statement as expenses.
What is the most challenging part of accounting for legal retainers?
The hardest part of legal retainer accounting is going to be on the law firm’s accounting and financial management. They should be keeping those fees in a trust account, and then recognizing their revenue as services are performed.
From a client’s perspective, one of the challenges of doing accrual accounting for legal retainers is that legal firms are notorious for late billing. This can make it difficult for clients to accurately account for their legal expenses and prepaid assets.
In order to properly account for legal retainers, clients may need to go back to previous month’s books and update their expenses and prepaid asset balances. This can be a time-consuming process that requires a significant amount of attention to detail.
Furthermore, if the legal matter continues beyond the end of the accounting period, clients may need to estimate the amount of work that will be performed in the future and adjust their accruals accordingly. This can be challenging, as legal matters can be complex and unpredictable.
Overall, accurate accrual accounting for legal retainers requires proactive communication with the legal firm and careful monitoring of legal expenses and prepaid assets. Clients may need to be prepared to make adjustments to their books in order to ensure accurate and timely financial reporting.