How to Record Retainers and Settlements in Your Firm’s Journal

Law firms handle intricate financial transactions daily, with retainers and settlements being particularly scrutinized. These transactions involve client funds that must be meticulously tracked, accurately reported, and kept separate from operating capital in line with professional standards. Errors can lead to malpractice claims, disciplinary actions, or expensive audits, making precise bookkeeping both an ethical and operational necessity.

Thankfully, a clear path is available. By grasping the nature of retainers, the flow of settlement funds, and the correct journal entries for each phase, legal practices can adhere to trust-account rules, comply with generally accepted accounting principles (GAAP), and enhance cash-flow transparency. This guide outlines the most crucial aspects, providing practical examples from small, midsize, and large firms.

Understanding Retainers and Settlements

Retainers and settlements may share a place inside a trust account, yet they differ dramatically in purpose, timing, and the rules that govern them. Confusing one for the other can skew financial statements and invite disciplinary action from the state bar.

Below is a closer look at how the two instruments operate, why courts and bar associations treat them differently, and what that means for the firm’s general ledger.

What is a retainer?

A retainer is an advance payment placed with a lawyer to secure future services. According to the American Bar Association’s 2023 TechReport, 82 percent of solo and small firms rely on retainer arrangements for at least half of their matters. Once the money arrives, it legally belongs to the client until the attorney earns it through billable work. For that reason, state bars require that retainers be deposited in an Interest on Lawyers’ Trust Account (IOLTA) or other designated trust vehicle rather than the firm’s operating account.

Retainers come in three common varieties: (1) general retainers that compensate the lawyer for being available to the client, (2) security retainers that act as deposits for future fees, and (3) advance fee retainers applied to specific tasks. Each has distinct billing triggers, but the accounting mechanics remain similar—money moves from trust to revenue only when services have been rendered and the client has been billed.

What is a legal settlement?

A legal settlement represents funds received from a third party, usually the opposing party or an insurance carrier, to resolve a dispute. Unlike a retainer, settlement proceeds are not payments for legal services; they are payments intended for the client. Consequently, every jurisdiction requires that settlement money be placed in a trust or escrow account until disbursement instructions are complete.

Because the firm may also draw fees and costs from the settlement, a meticulous record is essential. The Journal of Legal Economics notes that fee disputes arise in nearly eight percent of U.S. settlements over $100,000, often because the supporting ledgers do not reconcile. Proper journal entries not only meet regulatory standards but protect the practice against claims of misappropriation.

Trust Accounting and Retainers

Trust accounting rules exist to protect client property and ensure lawyers do not commingle operating money with funds that do not belong to the firm. Each state bar publishes granular guidelines detailing how long funds may remain in trust, how often reconciliations are performed, and what information must appear on the client ledger.

Best practice calls for a three-way reconciliation every 30 days, comparing (1) the trust-account bank statement, (2) the trust subsidiary ledger listing each client’s balance, and (3) the master trust ledger. If any of the three figures fail to match, the discrepancy must be researched immediately. Accurate journal entries are the backbone of this reconciliation process.

Recording Journal Entries: Step-by-Step

The journal-entry workflow for retainers and settlements follows a predictable sequence. First, record the deposit in the trust account as a debit to Trust Bank and a credit to Client Trust Liability. Second, when fees are earned or costs advanced, create a bill in the practice-management system. Third, transfer the earned amount from the trust account to the operating account and record a debit to Client Trust Liability and a credit to Trust Bank, with a reciprocal entry in operating books to recognize revenue.

For settlements, begin by depositing the check into the trust account, again debiting Trust Bank and crediting Client Trust Liability. Next, draft the settlement statement and cut disbursement checks to each stakeholder. Each payment yields a debit to Client Trust Liability and a credit to Trust Bank. The firm’s fee portion also appears as revenue in the operating ledger, mirroring the retainer workflow once money becomes the firm’s property.

Every step should be supported by source documents, including engagement letters, settlement agreements, and client invoices. Keeping digital copies attached to the journal entry in modern accounting software expedites audits and simplifies staff training.

Why Accurate Journal Entries Matter

Meticulous journal entries do more than keep the books tidy; they protect licenses, secure a competitive edge, and avert tax headaches. A 2023 survey by the Legal Management Institute found that 37% of midsize firms that failed a random trust audit had to refund or replace client funds, costing an average of $18,400 per incident. Precise accounting is, quite literally, money in the bank.

Beyond the immediate financial risk, poorly maintained ledgers can erode confidence with sophisticated corporate clients who routinely require audits of outside counsel. Law departments increasingly treat solid financial controls as part of due diligence when selecting firms, meaning that sloppy bookkeeping can quietly disqualify a firm from high-value work.

State bar compliance and risk of audit.

Most state bars reserve the right to conduct random trust-account audits, and several—including Florida, New Jersey, and California—have dramatically increased audit frequency over the past decade. Firms that cannot produce reconciled ledgers within the required time frame may face suspension, fines, or mandatory supervision. Properly recorded journal entries shorten audit response time from days to mere hours.

In addition, states such as Illinois require an annual verification of trust procedures signed by the managing partner. If journal entries fail to match underlying bank activity, that attestation could become the basis for a disciplinary proceeding, exposing the entire partnership to liability.

Read more: How to Set Up Vendor Profiles for Court Fees, Experts, and Clients in Bill.com

Maintaining client trust and financial transparency.

Transparency is a differentiator in a marketplace crowded with legal service providers. When clients can request a real-time ledger of their retainer or settlement proceeds and receive it within minutes, trust deepens. Clear journal entries make producing that statement effortless, enhancing the client experience and reducing billing disputes.

Client trust also extends to data security. Cloud-based accounting platforms, when properly configured, provide encryption and granular permissions, ensuring that only authorized personnel can access sensitive trust information. Accurate entries paired with secure systems demonstrate a firm’s commitment to safeguarding client assets on every front.

Read more: How to Manage Client Refunds and Unearned Fees in IOLTA

IRS and tax implications for law firms.

The Internal Revenue Service draws a bright line between earned and unearned income. Improperly recognizing retainer funds as revenue before they are earned inflates taxable income and can trigger penalties for underpayment or erroneous returns in subsequent years. Conversely, failing to recognize earned fees on time may lead to costly amendments.

In contingency-fee practices, settlement funds present additional complexity. The firm must allocate income between partners, account for deductible case costs, and issue Form 1099s to any payee who exceeds the $600 reporting threshold. Accurate journal entries create an audit trail that substantiates each figure on the return, reducing the risk of IRS adjustments.

How Irvine Bookkeeping Helps Law Firms

Irvine Bookkeeping specializes in legal-industry accounting, offering a blend of CPA-supervised expertise and cutting-edge technology. The firm’s legal bookkeeping team sets up customized chart-of-accounts structures that clearly separate trust, operating, and reimbursement activities, ensuring every retainer or settlement entry lands in the right ledger the first time.

Beyond initial setup, Irvine Bookkeeping provides ongoing reconciliations, monthly compliance reports, and on-demand audit support. Its professionals are fluent in practice-management platforms such as Clio, LeanLaw, and PracticePanther, making integrations seamless. That end-to-end service frees attorneys to focus on advocacy while knowing that every penny is recorded, reconciled, and ready for inspection.

Conclusion

Retainers and settlements sit at the heart of a law firm’s cash flow, yet mishandling them can jeopardize licensure, invite audits, and erode client confidence. By understanding the legal definitions, following a disciplined journal-entry workflow, and embracing trust-account best practices, firms position themselves for ethical and financial success.