Trust accounting: a comprehensive guide to managing client funds safely and compliantly

As an accountant, there are various situations where you may be entrusted with holding money on behalf of clients. For example, a client may pay upfront for services not yet delivered. It’s your job to ensure that this money is managed properly and separately for your own funds. This is known as trust accounting. 

Trust accounting plays a crucial role in areas such as legal services, real estate purchases, and estate planning. It ensures this process is undertaken securely, transparently, and in compliance with the latest regulatory requirements.

In this guide, we’ll explain everything you need to know about trust accounting. We’ll explore best practices and essential tools for managing trust accounts effectively. By the end, you’ll have the information you need to handle client funds responsibly.

What is trust accounting?

Trust accounting is a specialized branch of financial management. It focuses on the proper handling, recording, and reporting of funds held in trust on behalf of clients or third parties. 

Where regular accounting involves managing a company’s own finances, accounting for trusts involves temporarily holding funds that do not belong to the organization. This can be done for various reasons, including: 

• Legal settlements — funds are held until a legal case is concluded
• Real estate transactions — funds are held during the conveyancing process
• Client retainers — funds are held until services have been completed

Trust accounting has its own regulations and standards. These rules ensure transparency and prevent client funds from being mismanaged. 

Effective trust accounting offers significant advantages. It significantly reduces the risk of financial mismanagement and ensures legal compliance. At the same time, it fosters trust between service providers and their clients. 

What is a client trust account?

A client trust account is a dedicated bank account that accountants or legal professionals use to hold funds on behalf of their clients. The main purpose of a trust account is to ensure that client funds are protected, accurately accounted for, and used solely for their intended purposes.

There are two main types of client trust accounts:

• Pooled trust accounts. These accounts hold funds from multiple different clients in one place. Each client’s funds are tracked and safeguarded. Pooled accounts are typically used for smaller transactions or short-term holdings, as opening separate accounts for each client would be inefficient.
• Separate trust accounts. These accounts are set up for individual clients. They tend to be used for larger transactions. Separate trust accounts allow for greater transparency, making it easier to monitor and report on specific client funds.

What is IOLTA?

IOLTA is short for Interest on Lawyers’ Trust Accounts. An IOLTA account is a type of pooled trust account that allows the interest earned on funds to be used for public or charitable initiatives. For example, IOLTA accounts may direct interest payments towards legal aid services.

While the funds in an IOLTA account belong to clients, the interest generated does not. Rather, it is distributed to state-sponsored IOLTA programs. So in addition to safeguarding client funds, IOLTA accounts also contribute to important social and legal causes.

Key differences between IOLTA and client trust accounts

While both IOLTA and client trust accounts are used to safeguard client funds, they differ in several key ways:

Purpose:

• IOLTA accounts are used to hold smaller client funds for shorter amounts of time. The interest earned on these combined funds is then reallocated to charitable programs.
• Client trust accounts, on the other hand, can be used to hold either small amounts from multiple clients (pooled trust accounts) or larger sums or long-term holdings (separate trust accounts). 

Interest:

• In IOLTA accounts, any interest generated is transferred to designated social programs rather than to the client.
• In separate trust accounts, any interest earned typically goes to the client — unless otherwise agreed upon.

Legal requirements:

• Accountants and lawyers are legally required to deposit client funds into some kind of trust account — whether that’s an IOLTA account or a client trust account. 
• While all US states have IOLTA programs, only 44 of them require them to be used. In the remaining states, IOLTA accounts can be used at the discretion of the accountant and client.

Best practices for effective trust accounting

Effective trust accounting is crucial for a number of reasons. Besides ensuring regulatory compliance, it also fosters trust between you and your clients. In this section, we’ll look at some best practices for managing client trust accounts securely and efficiently. 

1. Avoid commingling of funds

One of the fundamental principles of trust accounting is to keep client funds separate from business or personal funds. In other words, all client funds should be held in a dedicated trust account. Not only is this the right thing to do from an accounting perspective, but it’s also mandatory from a compliance perspective in most jurisdictions.

To avoid commingling of funds, here are some best practices to follow:

• Label your client trust account clearly to avoid mistakes
• Only deposit client funds into the trust account
• Avoid using trust account funds for operational expenses

2. Maintain detailed records and ledgers

Accurate record-keeping is essential in trust accounting. While this is true for all client trust accounts, it’s especially important for pooled accounts, where small amounts are held from different clients in one account. 

We recommend recording and documenting every transaction involving client funds. You should also ensure that these records are readily accessible for audits or compliance checks. 

Here are some best practices to consider when maintaining records of client trust accounts:

• Create individual client ledgers for each trust account transaction
• Record all deposits and withdrawals with clear descriptions
• Record transaction dates, amounts, and purposes
• Keep supporting documentation, such as payment authorizations, invoices, and bank statements

We also recommend using accounting software designed for trust accounting. This can help simplify the process of tracking and recording client transactions. The right software also improves the auditability of your records.

3. Reconcile trust accounts regularly

Reconciling your client trust accounts regularly ensures that your client ledgers, bank statements, and trust account balances match. It can help you identify and address any issues early on, before they become significant problems. Here are some best practices to consider when reconciling trust accounts:

• Perform reconciliations once a month — or at the very least once a quarter
• Compare bank statements with internal trust account records
• Investigate and resolve any discrepancies immediately
• Maintain reconciliation reports for audit purposes

Again, technology can help streamline this process. With the right accounting software, you can automate the manual steps involved in account reconciliation and receive alerts when mismatches occur.

4. Disburse funds only once earned or authorized

Client funds must be held in a trust account until you are authorized to release them. This could be because you have legally earned the funds by delivering certain services, or because the client explicitly requests that you do. Make sure the details of when funds can be disbursed are set out in the terms of the fund account. 

Disbursing client funds prematurely is considered a serious breach of trust accounting rules. To avoid such issues:

• Ensure written authorization for every disbursement
• Verify that funds have been earned before withdrawing
• Avoid transferring funds from one client’s account to cover another client’s expenses
• Document all disbursements with detailed records

5. Implement strong internal controls

Implementing robust internal controls and documenting procedures helps everyone in your organization adhere to predetermined steps and standards. It also ensures that no single person has complete control over trust fund management. This significantly reduces the risk of fraud or oversight.

Ideally, you should include the following points in your internal controls: 

• Segregate duties among team members 
• Require significant transactions to be authorized
• Perform regular internal and external audits of trust accounts
• Use automated software to detect irregular activities

6. Comply with local laws and regulations

Trust accounting laws vary across different jurisdictions, so make sure you’re aware of the regulatory requirements in your state or country. Failure to comply with the relevant requirements can result in financial penalties. In some cases, it could even lead to your license being suspended or legal action.

To stay compliant with the relevant laws and regulations, you should:

• Keep up to date with the latest regulations and guidelines
• Update your internal controls and processes in line with the latest regulatory changes
• Ensure all reporting requirements are met on time
• Retain trust account records for the required period (usually five years or more)
• Work with legal or financial professionals when in doubt

7. Educate staff

Trust accounting is often a team effort. Everyone involved at your accounting practice should understand trust accounting best practices and regulatory requirements. They should also understand their roles and responsibilities. The best way to ensure this is through regular training sessions.

Make sure you build trust accounting training into your employee onboarding process. Once up and running, your training programs should include:

• Clear explanations of trust account procedures
• Guidance on compliance and regulatory requirements
• Hands-on training for trust accounting software
• Regular updates on changing laws and guidelines

Common mistakes in trust accounting

Like any aspect of accounting, trust accounting can be complex and prone to human error. The best way to avoid issues is to understand the most common errors — and put safeguards in place. 

Here are some of the most common trust accounting errors and the consequences that can arise as a result:

• Commingling of funds. Mixing client funds with personal or business funds is one of the most serious violations in trust accounting. It can lead to difficulty in tracking client money and potential legal consequences.
• Poor record keeping. Failure to effectively document deposits, withdrawals, and transactions can result in compliance breaches and failed audits. 
• Misappropriation of funds. Using client funds for unauthorized purposes can have wide-ranging consequences — from damaged professional credibility to legal repercussions.
• Failure to comply with regulations. Trust accounting rules vary from region to region. Failure to adhere to the relevant laws can lead to hefty penalties and a loss of client trust.
• Lack of segregation of duties. Having one person in charge of all aspects of trust accounting increases the risk of errors or fraud going unnoticed. 
• Delayed disbursements. Holding client funds longer than necessary can lead to client disputes and potential legal disputes.
• Inadequate supervision. Without regular internal audits or reviews, errors and inconsistencies may go unnoticed. These issues can compound over time.

Tools and software for trust accounting

Most of the issues we outlined above can be avoided by leveraging modern technology. There are all sorts of tools you can use to streamline and automate trust accounting processes. Dedicated trust accounting tools can improve accuracy and efficiency. They can also enhance your compliance efforts and leave detailed audit trails. Examples include QuickBooks Online, Xero, and Clio. 

When choosing a trust accounting platform, we recommend looking for the following key features: 

• Automated reconciliation
• Detailed reporting
• Transaction tracking
• Audit trails 
• Integration capabilities

Besides trust accounting software, there are a range of different systems you can use to streamline internal operations and stay organized. TaxDome is a prime example. 

As a complete practice management platform, TaxDome enables you to automate entire workflows. It provides tools for managing projects, teams, and clients — ensuring transparency and accountability at every step of the trust accounting process. 

The bottom line

As an accountant, you are legally obligated to hold client funds in a trust account. By following the best practices we’ve outlined in this guide, you’ll be able to keep client funds safe and secure at all times.

Technology can help streamline this process. Dedicated trust management software can automate account reconciliations, flag issues, and help ensure legal compliance and audibility. But that’s not all. With a platform like TaxDome, you can streamline the operational side of trust accounting. 

With automated accounting workflows and a powerful set of practice management tools, TaxDome helps firms work smarter and faster — all while delivering an exceptional client experience. 

To see how TaxDome can streamline your accounting, bookkeeping, and tax workflows, request a demo today!