7.1 Accounting Terminology, Balance Sheets, Income Statements & Timekeeping Records
Key Takeaways
- Billing and Accounting is a named heading in PP Part 2, and it tests bookkeeping vocabulary and law-office procedure rather than the ethics of client funds, which belongs to Part 3.
- The accounting equation, assets equal liabilities plus owner's equity, is the structural basis of the balance sheet and must always remain in balance.
- A balance sheet reports financial position at a single point in time, while a profit and loss statement reports results across a period, so the two answer different questions.
- Most law firms keep books on the cash basis, recognizing revenue when a client payment is received rather than when the invoice is issued, which makes accounts receivable a management figure rather than recognized income.
- Time sheets, activity registers, and diaries are the source records that convert professional effort into billable value, and an entry not contemporaneously recorded is usually an entry never billed.
7.1 Accounting Terminology, Balance Sheets, Income Statements & Timekeeping Records
[!NOTE] NALS PP Exam Blueprint Focus: Billing and Accounting is one of the three headings under Part 2, The Law Firm: Office Procedures & Knowledge, and the outline enumerates its subtopics in unusual detail — balance sheets, profit and loss statements, activity registers, time sheets, and diaries among them. This is bookkeeping vocabulary tested for professional literacy, not for CPA-level analysis.
The Accounting Equation
Everything in double-entry bookkeeping rests on one identity:
Assets = Liabilities + Owner's Equity
| Element | Definition | Law-firm examples |
|---|---|---|
| Assets | What the firm owns or is owed | Operating cash, accounts receivable, unbilled work in process, furniture, library, leasehold improvements |
| Liabilities | What the firm owes | Accounts payable, accrued payroll, line of credit, equipment lease obligations, deferred rent |
| Owner's equity | The residual claim of the owners | Partner capital accounts, retained earnings |
The equation must balance after every transaction, because every entry affects at least two accounts. Pay a $3,000 vendor invoice from operating cash and assets fall by $3,000 while liabilities fall by $3,000; the equation holds.
Debits and credits are the mechanics of that dual entry. A debit increases assets and expenses and decreases liabilities, equity, and revenue; a credit does the reverse. Total debits must equal total credits in every transaction, which is the internal check that gives double-entry bookkeeping its name.
The Balance Sheet
A balance sheet is a snapshot of financial position as of a single date. It presents the three elements of the accounting equation and, by construction, balances.
| Section | Contents |
|---|---|
| Current assets | Operating cash, accounts receivable, prepaid expenses, client cost advances receivable |
| Fixed assets | Furniture, equipment, leasehold improvements, less accumulated depreciation |
| Current liabilities | Accounts payable, accrued payroll and taxes, current portion of debt |
| Long-term liabilities | Notes payable, long-term lease obligations |
| Owner's equity | Partner capital accounts, retained earnings |
[!WARNING] Client trust funds are not firm assets. Money held in a client trust account belongs to clients. It is not part of the firm's equity, is never available to pay firm expenses, and is reported and reconciled separately from the firm's own books. Treating a trust balance as a firm asset is both an accounting error and an ethical violation.
The Profit and Loss Statement
A profit and loss statement, also called an income statement, reports results over a period — a month, a quarter, a year.
Its structure is subtraction:
| Line | Law-firm content |
|---|---|
| Revenue | Fees collected, and in some firms reimbursed costs |
| Less: Operating expenses | Salaries and benefits, rent, malpractice insurance, research subscriptions, filing and court costs not reimbursed, depreciation |
| Equals: Net income | The amount available to the owners |
| Balance sheet | Profit and loss statement | |
|---|---|---|
| Time frame | A point in time ("as of December 31") | A period ("for the year ended December 31") |
| Question answered | What does the firm own and owe right now? | Did the firm make money over the period? |
| Governing identity | Assets = Liabilities + Equity | Revenue − Expenses = Net income |
The two connect: net income from the income statement flows into retained earnings on the balance sheet.
Cash Basis Versus Accrual Basis
| Cash basis | Accrual basis | |
|---|---|---|
| Revenue recognized | When payment is received | When the fee is earned |
| Expense recognized | When paid | When incurred |
| Typical user | Most law firms | Larger commercial enterprises |
Most law firms keep books on the cash basis. The consequence is that an issued but unpaid invoice is not revenue. Accounts receivable — billed but uncollected fees — and work in process — recorded time not yet billed — are management figures that measure the pipeline, not recognized income. A firm that mistakes a large receivable balance for profitability is a firm about to have a cash crisis.
Timekeeping: Time Sheets, Activity Registers & Diaries
Time is the firm's inventory. The records the outline names are the mechanisms that convert effort into billable value.
| Record | What it captures |
|---|---|
| Time sheet | Timekeeper, date, client, matter, task description, time spent, billing rate |
| Activity register | Chronological log of activity on a matter across all timekeepers |
| Diary | Daily record of appearances, conferences, and calls, often doubling as a calendar |
| Cost or disbursement record | Filing fees, service fees, deposition transcripts, expert fees, travel advanced on the client's behalf |
Most firms bill in tenths of an hour, so 0.1 equals six minutes and 0.3 equals eighteen minutes. Some use quarter-hour increments.
A defensible time entry names who, what, for which matter, and how long, in terms a client can evaluate:
- Weak: "Research — 3.4"
- Defensible: "Research Ninth Circuit authority on tolling of the limitations period during administrative exhaustion; draft memorandum summarizing four controlling cases — 3.4"
Three rules govern timekeeping practice:
- Record contemporaneously. Time reconstructed at the end of the week is systematically understated and difficult to defend in a fee dispute.
- Never bill the same hour twice. If travel time for one client is spent working on another matter, only one client may be billed for that hour.
- Bill only work actually performed. Model Rule 1.5 forbids an unreasonable fee, and billing for work not done is fraud, not aggressive billing.
Realization and Collection
Three ratios describe how much recorded value survives to become cash:
- Billable hours recorded — the raw input.
- Realization rate — the proportion of recorded value actually billed after write-downs.
- Collection rate — the proportion of billed value actually received.
A firm recording 1,000 hours at $200 has $200,000 of recorded value; at 90% realization it bills $180,000; at 92% collection it receives $165,600. That final figure, not the first, is what the cash-basis income statement reports.
Petty Cash and the Imprest System
A petty cash fund handles small disbursements — postage due, parking for a filing run, courier tips — without writing a check for each. It runs on the imprest system:
- The fund is established at a fixed amount, say $300, by a single check to Petty Cash.
- Every disbursement is supported by a voucher or receipt placed in the box.
- At any moment, cash on hand plus vouchers must equal the fixed fund amount.
- Replenishment is by a check for the total of the vouchers, restoring the fund to $300, and the expense accounts are charged at that time.
The fixed total is the control: a shortage is visible immediately because the cash and vouchers no longer add to the established amount. Client costs advanced from petty cash must still be recorded to the matter so they appear on the client's bill.
A firm's bookkeeper reports that the firm issued $410,000 in invoices during the quarter and collected $290,000. The firm keeps its books on the cash basis. What revenue appears on the quarterly profit and loss statement?
A firm establishes a $250 petty cash fund on the imprest system. At the end of the month the box contains $62 in cash and vouchers totaling $181. What does this indicate, and what replenishment check should be written?
A managing partner asks which financial statement shows whether the firm can meet its obligations as of the last day of the fiscal year. Which statement answers that question, and why?