Trust Account Balance Sheets:
Understanding Liability and Equity
As the owner of a law firm, it’s your responsibility to keep up with monthly reconciliation and financial recordkeeping. Even if you have an accountant, you need to review your firm’s numbers so that you have first-hand knowledge of how the firm is doing.
Because your training is in law rather than accounting, certain elements of legal bookkeeping can feel unfamiliar at first. Client trust bank accounts are a common example. These funds appear as liabilities on the balance sheet, and that classification often surprises attorneys who are new to trust accounting.
We’ll walk through the accounting foundations that govern these accounts, including why some balances fall under liability, how equity fits into the equation, and what these categories reveal about your firm’s financial health.
Trust Accounts Explained: A Quick Overview
Before we break down what liability and equity represent on your balance sheet and how funds move between these categories, let’s quickly review the basics of trust accounting.
Client Trust Bank Accounts Hold Money You Safeguard on Behalf of a Client.
These funds may come from retainer fees, settlement proceeds, or any situation in which you’re acting as a fiduciary for a client or their estate. In every scenario, the money in a trust bank account legally belongs to the client, even though you manage the account for them.
Because the Funds Aren’t Yours, Detailed Records Are Essential.
Every dollar that enters or leaves the account must be documented with precision for your firm to maintain compliance. These records serve as proof that client funds are handled properly, kept separate from operating accounts, and remain fully intact.
Auditors Expect Complete Records and Supporting Documentation.
Regulators want to see complete trust accounting records and documents in the event you’re audited. This includes ledgers, deposits, disbursements, invoices, and all related financial activity. Auditors must be able to trace every transaction without gaps.
Attorneys Must Run Monthly Reconciliation and Three-way Reconciliation.
While the process can feel tedious, three-way reconciliation is one of the most effective ways to identify discrepancies early—before they grow into compliance violations. Firms that prefer to streamline reconciliations often rely on legal trust accounting software to handle the monthly work and provide accurate reports.
Funds Transition into Firm Revenue Once Legal Services Are Delivered.
At that point, the firm transfers the earned portion into its operating account. For example, when a retainer is held in trust, it stays classified as unearned until you complete billable work. After services are performed, you issue an invoice that clearly describes the work provided and withdraw the corresponding amount from the trust into the operating account.
A solid grasp of liability and equity sets the foundation. Take the next step by downloading 4 Trending Challenges in Trust Accounting (and How to Avoid Them) to strengthen your workflows and stay in full compliance.
Why Trust Accounts Are a Liability on Your Balance Sheet
Understanding why trust accounts appear as liabilities becomes far easier once the underlying accounting structure is clear. Trust accounting follows the same rules as every other business ledger, and those rules are designed to reflect who owns the funds and how those funds flow through your firm.
The Accounting Equation: Assets = Liability + Equity
When you review your balance sheet each month, the money in your client trust accounts appears as a liability. To understand why, start with the accounting equation:
Assets = Liability + Equity
Your trust bank account balance is listed as an asset on the left side of the balance sheet. The right side of the balance sheet shows liability and equity. By design, the totals on both sides must match.
Here’s how that plays out:
- When a client retainer is deposited into a trust bank account, the asset balance increases. But these funds are still client property, not earned revenue.
- To keep the balance sheet aligned, the liability section increases by the same amount.
- This mirroring ensures the balance sheet remains accurate and reflects who legally owns the funds being held.
Liability vs. Equity Explained
Liability represents money a business owes to someone who is not an owner.
In trust accounting, the balance in a trust account fits this definition because the funds belong to a client. Even though the law firm oversees the account, the money remains client property until it becomes earned revenue.
Equity represents the portion of assets that belongs to the owner after liabilities are deducted.
In a law firm, equity increases only when legal services have been performed, billed appropriately, and paid.
Once work is completed, the firm issues an invoice that details the services provided. At that point, the corresponding amount may be transferred from the account to the operating account. This earned portion is now owner property and appears in equity rather than liability.
Because trust accounts contain client-owned funds, they consistently appear as liabilities on the balance sheet, and the firm’s operating account reflects the amounts that have been earned.
Ethical Obligations and Compliance for Trust Bank Accounts
Clients place a significant level of trust is placed in any fiduciary, including attorneys who manage client funds. Clients rely on you to safeguard their money and handle every transaction with precision and transparency.
With this responsibility come specific ethical duties. The American Bar Association’s Model Rule 1.15 sets the standards for how funds must be handled, including what may be deposited into and withdrawn from trust accounts. Each state bar also establishes its own regulations. These rules guide the day-to-day management of trust bank accounts.
It’s your responsibility to know and follow your jurisdiction’s trust account guidelines. They will vary by location, but all require that you keep the client’s money in the trust account and your earned money in the law firm’s operating account. Proper separation protects clients, preserves compliance, and reinforces the integrity of your practice.
Leveraging Technology for Compliant Trust Accounting
The distinctions between what money belongs to you and what belongs to the client may seem obvious. But once you’re juggling multiple client trust accounts, an IOLTA account, and accepting credit card payments, things can get murky fast.
For credit card and other online payments, using a legal-specific merchant is one of the most reliable safeguards. Legal-focused payment tools like CosmoLexPay are designed to deposit client payments into the appropriate bank account while directing processing fees to the firm’s operating account.
This structure protects you from incorrect withdrawals or accidental commingling, both of which can create compliance violations.
Modern law practice management systems also play an important role in maintaining trust accounting integrity. Strong systems include built-in trust safeguards and alerts. For example, CosmoLex blocks transactions that would create a negative trust ledger balance and ensures every disbursement is properly linked to supporting documentation.
Automation further strengthens compliance. When your billing and accounting systems work together, the workflow becomes more consistent and far less vulnerable to manual error. Legal trust accounting software can also run required three-way reconciliations, making monthly compliance checks faster and more accurate.
Legal-specific credit card processing, built-in trust accounting protections, and automation that reduces financial risk are essential features to look for in any modern practice management solution. These tools save time, support compliance, and help your firm operate with confidence.
The Bottom Line: Keep Trust Accounting Simple
Even with a clear understanding of liability and equity, the real risks appear in the day-to-day details. Missed reconciliations, improper credit card handling, commingled funds, and incomplete client ledgers are 4 of the most common trust accounting mistakes—and each one can put your firm’s reputation, finances, and license at risk.
The best way to avoid these high-stakes errors? Set up workflows that prevent them from happening. Download our free guide, 4 Trending Challenges in Trust Accounting (and How to Avoid Them), to learn how to build safeguards into your daily processes and protect your firm with confidence.
Once you’ve reviewed the guide, you can explore how CosmoLex helps keep your firm compliant with built-in trust accounting automation, full legal accounting tools, time and billing, and complete practice management.
Book a quick demo or free trial now to get started.
Frequently Asked Questions About Trust Account Balance Sheets
Why are client trust funds considered a liability?
Client trust accounts are considered a liability on a law firm’s balance sheet because the money legally belongs to the client, not the firm. The firm has an obligation to hold and manage these funds, which is the definition of a liability.
What is the difference between a trust account and an operating account?
A trust bank account holds money that belongs to a client, while an operating account holds money that a law firm has earned. Trust accounts are liabilities on the balance sheet; operating accounts are assets.
How does equity relate to a trust account?
Equity represents the owner’s share of a firm’s assets after all liabilities have been deducted. Money in a trust account never counts as a firm’s equity because it is not owned by the firm.
Can a lawyer use money from a trust bank account?
No, a lawyer cannot use money from a trust account for personal or firm expenses. Doing so is considered commingling and is a serious ethical violation. Funds can only be withdrawn once they have been earned and properly invoiced.
