In theory, there are multiple ways to track client expenses in QuickBooks. However, in practice, there is a best way, which perhaps is the “right way”.
I will state that I am not an accountant, and before making any change you should speak with your accountant. My knowledge and opinions are based on my own understanding of the IRS rules.
Typically, when you pay a vendor, it’s considered an expense. A check written to pay this expense would Credit your bank account and Debit the appropriate expense account. This works fine except when law firms pay expenses on behalf of clients. Although most law firms record income and expense on a cash basis, the handling of “Advanced Client Costs” is an exception, sometimes referred to a Modified Cash Expense.
The IRS considers these Advanced Client Costs to be a loan. When the client repays the expense that is re-payment of the loan. Loans should be tracked on the balance sheet, not the profit & loss statement. Therefore, Advanced Client Costs belong on the balance sheet as an Asset, usually an Other Current Asset. If clients do not repay these costs you can write them off.
Whether the IRS requires it, or not, there other good reasons to track Advanced Client Costs on the balance sheet. It’s important to be able to tell how much you have expended on behalf of a client and what they have repaid. If you track these costs on the balance sheet, and always include the client name, then it is easy to run a report that shows detail by client. If you are tracking on the income statement; this report is harder to run as at the end of each fiscal year the amounts are “transferred” to retained earnings in accordance with general accounting procedures. Additionally, if you are trying to compare your profits from year to year, ups and downs in the Advanced Client Costs can easily skew reports if the amounts are tracked on the income statement.
It is important to note that if you are invoicing clients for expenses through QuickBooks, and you do not expect to get paid in full, you should invoice fees and expenses on separate invoices. While this may seem like extra work, it is worthwhile. This is because when partial payment is received on an invoice, QuickBooks applies it proportionately across the line items on the invoice. This is usually not what you want.
By way of an example, assume I bill a client $1000 for fees and $50 for filing fees I advanced on their behalf. If they client pays the $50 for expenses on December 31st I have two very different scenarios if I billed on one invoice or two.
If I billed on two separate invoices, I record the payment against the expense invoice and I have no “income impact” for the year. However, if I billed everything on one invoice, the $50 payment is applied proportionately and $47.62 is income with only $2.38 reducing the advanced client costs account. I will have to pay tax on the $47.62 even though that was not the intention. While I know the tax on $47.62 is generally not worth worrying about, this is a simple example. In a busy firm the amounts could be substantially higher and we are paying taxes incorrectly.
While you can, at the end of each year, figure out what was disbursed / received on client expenses and make appropriate adjustments this takes extra work. Whether you are doing these calculations or your accountant is doing them, you are paying for it. You can save time and money by tracking client expenses on the balance sheet and by billing for them separately.