How to Prepare a Law Firm for the End-of-Year Audit

As the year winds down, your law firm has a familiar task ahead: end-of-year audit. This might seem like just another item on your to-do list, but it’s actually one of the most important things you can do to keep your firm financially healthy and compliant.

End-of-year audits for law firms come in two main forms. Internal audits are self-conducted reviews where you examine your own financial records, compliance procedures, and operational processes. These help you identify potential issues before external parties discover them. External audits, on the other hand, are conducted by independent certified public accountants (CPAs) who provide an objective assessment of your financial statements and compliance with professional standards.

But, many law firms approach audit season with last minute scrambling. Without proper preparation, you risk discovering compliance issues, financial discrepancies, or operational problems that could have been addressed proactively.

The good news is there are practical steps that will help you prepare for your end-of-year audit, and we’ve outlined them for you.

Step 1: Get Your Financial Records in Order

Start by gathering all financial documents from the past year. This includes bank statements, credit card statements, invoices, receipts, and any other records of financial transactions. Create both physical and digital filing systems that make sense for your practice.

Separate your operating account records from trust account records, as these will be reviewed differently during the audit. Make sure you have complete records for every transaction involving client money.

If you use practice management software or accounting programs, ensure all data is backed up and easily accessible. Print hard copies of important reports and reconciliations, as auditors often prefer physical documentation they can review and annotate.

Step 2: Reconcile All Bank Accounts

Bank reconciliations should be completed monthly, but many firms fall behind during busy periods. Before the audit, ensure that all bank accounts are reconciled through the end of the year. This means comparing your internal records with bank statements to identify and explain any discrepancies.

Create a summary of year-end bank balances for all accounts. This will serve as a starting point for the auditor and help them understand your firm's cash position.

Step 3: Review Trust Account Management

Trust account compliance receives intense scrutiny during audits. Review your trust account activity and ledger to ensure it accurately reflects all client balances. The total of individual client balances must match your bank account balance exactly.

Look for any unusual transactions, such as negative balances in individual client ledgers or transfers that don't have proper documentation. These issues need to be addressed before the audit begins. Prepare a detailed year-end listing of all clients with funds in trust, including client name, matter number, and balance.

Step 4: Compile Accounts Receivable and Work-in-Progress

Create an accounts receivable aging report categorizing outstanding invoices by age (current, 30, 60, 90+ days). Be realistic about collectibility and consider allowances for doubtful accounts.

Document your work-in-progress for cases that are ongoing but not yet billed. This includes time entries, expense advances, and any costs incurred on behalf of clients. Review billing procedures for consistency, auditors will verify that time entries are contemporaneous, detailed, and properly allocated between matters.

Step 5: Review Accounts Payable and Accrued Expenses

Gather all unpaid vendor invoices and create a comprehensive accounts payable listing. This should include regular operating expenses like rent, utilities, and office supplies, as well as professional services such as IT support, marketing, and research.

Don't overlook accrued expenses like insurance premiums or consultant services you've received but haven't been billed for yet. Review your expense allocation methods for multiple practice areas or partnership arrangements. Auditors need to understand how shared expenses are divided and whether methods are reasonable and consistently applied.

Step 6: Document Fixed Assets and Depreciation

Create a detailed listing of all fixed assets, including office furniture, equipment, law library, and any other items with useful lives extending beyond one year. For each asset, document the purchase date, original cost, and accumulated depreciation.

Review depreciation methods for appropriateness and consistency. Consider writing off obsolete assets like old equipment or outdated law books, documenting your reasons for auditor review.

Step 7: Organize Payroll Records and Employee Files

Compile all payroll records for the year, including salary and wage information, tax withholdings, benefit deductions, and employer payroll tax payments. Ensure that all quarterly payroll tax returns have been filed and W-2s are prepared.

Review employee versus independent contractor classifications, as misclassification can result in significant penalties. Make sure you have appropriate documentation for independent contractor relationships, including Form 1099s for payments exceeding $600. Organize personnel files including employment agreements and benefit forms to help auditors understand your operations.

Step 8: Prepare Insurance and Professional Liability Documentation

Gather all insurance policies and verify that professional liability coverage meets state bar requirements. Document any coverage changes during the year and organize correspondence related to claims or potential claims.

Review your insurance allocation methods if premiums are shared among partners or practice groups. The allocation should be reasonable and consistently applied throughout the year.

Step 9: Review Partnership Agreements and Profit Distribution

If your firm operates as a partnership, organize all partnership agreements and profit distribution documentation. Auditors will review these documents to understand how income and expenses should be allocated among partners.

Prepare schedules showing each partner's capital account activity for the year, including contributions, distributions, and allocated profits or losses. These schedules should tie to your general ledger and partnership agreement terms.

Document any changes in partnership structure during the year, such as new partners joining, existing partners leaving, or modifications to profit-sharing arrangements. These changes can have significant financial and tax implications that auditors need to understand.

Step 10: Conduct a Pre-Audit Internal Review

Before the auditors arrive, conduct your own internal review of all the documentation you've prepared. Look for inconsistencies, missing information, or areas that might raise questions. 

Create a master checklist of all documents and schedules the auditors will need. Organize everything in a logical manner, either physically or electronically, so information can be quickly accessed during the audit process. Consider creating an index or summary document that explains your filing system.

Designate specific staff members to work with the auditors and ensure they understand their roles. The audit will proceed more smoothly if auditors have consistent points of contact who can locate information and answer questions promptly.

Why is a Law Firm Year-End Audit Important?

The year-end audit serves multiple purposes that directly impact your law firm's success and longevity. First and foremost, it ensures compliance with bar association rules and state regulations. Legal professionals are held to strict standards when it comes to financial management, particularly regarding client trust funds. A thorough audit helps verify that you're meeting these obligations and avoiding potential disciplinary actions.

From a business perspective, the audit provides a clear picture of your firm's financial health. You'll gain insights into your profitability, cash flow patterns, and areas where you might be losing money. This information is essential for strategic planning, whether you're considering expansion or making partnership decisions.

The audit process also helps identify operational inefficiencies and internal control weaknesses. You might discover that your billing procedures need refinement, your expense tracking could be more accurate, or your document retention policies require updates.

Additionally, if your firm plans to apply for loans, attract investors, or merge with another practice, having recently audited financial statements can strengthen your position. Banks and other stakeholders view audited statements as more reliable than unaudited ones, which can lead to better terms and increased confidence in your firm.

Final Note

Preparing for an end-of-year audit requires significant time and attention to detail, but the benefits extend far beyond mere compliance. The key to a successful audit is thorough preparation and organization. By following proactive steps, you can make the audit process smoother and get a better understanding of your firm's financial position.

Remember that audit preparation is an ongoing process, not a year-end scramble. Implementing good financial practices throughout the year makes the audit process much more manageable and reduces the stress associated with this important annual requirement.

If you're overwhelmed by the complexities of law firm financial management and audit preparation, consider partnering with specialists who understand your unique needs. At Bookkeeper.law, we provide bookkeepers and accountants specifically for law firms. Let us handle the details so you can focus on what you do best.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. For guidance specific to your law firm, it’s best to consult with a qualified legal professional.