Accrual Versus Cash Basis: Which Accounting Method Should Your Law Firm be Using?
Which accounting method does your law firm use? There are two options when it comes to accounting methods: cash basis or accrual basis. The primary difference between these two methods is the point at which revenue is recognized. Cash basis means the income is recognized at the time of receipt, and bill payments are recorded when the bills are paid. Accrual basis means a sale is recognized at the time of sale, even if the payment isn’t made for 90 days. The same goes for bill payments: if you make a purchase and don’t pay for 30 days the payment is still recorded for the date the purchase was made.
Most small businesses operate on a cash basis. Operating on a cash basis makes more sense for many small businesses, including small or solopreneur law firms. This is mostly due to the fact that it shows a more accurate depiction of the cash on-hand
Advantages of accrual basis accounting
While operating on an accrual basis isn’t the best way to gauge your current financial situation at any given moment, it is advantageous when looking at your overall company performance. This makes it easier to really see how the company is performing on an ongoing basis, and is a better depiction of your firm’s resources and financial responsibilities. Accrual based accounting makes determining how a firm ebbs and flows more recognizable, especially when creating reports to determine a firm’s overall profitability.
Disadvantages of accrual basis accounting
Another aspect to consider when operating on an accrual base is your cash flow. Let’s say you have $150,000 in your bank account as a true balance. Then you delivered legal services in the amount of $100,000 to clients. When operating on an accrual basis, as soon as the services contracted are completed, the sales are recognized. Now, say all of these clients have 90 days to to pay their invoices, and none have actually paid their balances yet. Based off of the accrual method, you now have $250,000 in your bank account. In reality, we know this isn’t a true balance. I’m sure you can see how this could cause problems!
There are also some potential tax disadvantages when using the accrual method for your accounting. Since income is recognized at the time of the sale and not when actually collected, it is possible to end up paying taxes on income that has not yet been collected. For example, if you finished a case for a client in December 2016, but they didn’t pay until January 2017, you would still responsible for paying the tax on that income on your 2016 tax return. This is why most tax preparers will perform an accrual-to-cash conversion when compiling your tax data.
Advantages of cash basis accounting
Operating on a cash basis tends to be simpler to understand, and also most resembles your firm’s cash flow statement. This is because entries are only recognized once payments are actually received and not when the services were rendered. Therefore, operating on a cash basis directly reflects cash on hand. For this to be true though, you need to ensure all bill payments made have also been recorded.
Disadvantages of cash basis accounting
Cash basis accounting can be misleading. For instance, when operating on a cash basis, it might appear that your firm had a stellar month in sales based on the income recognized. However, this data could potentially be false. The case very well could be that the month’s sales were, in fact, slow, but clients paid their invoices from months ago. This can be misleading and can hinder the creation of a successful growth plan.
The cash method also makes it more difficult to compare your firm to other companies that operate on an accrual basis.
Which accounting method is best for you?
There are various reasons to use one reporting method over another. Discussing these methods with your accountant is of paramount importance when deciding which one is best for your firm.
There are also some mandates from the IRS that can affect which method you may be required to use. Businesses that accrue more than $10 million in annual sales are required by law to implement the accrual method. There is a lower threshold of $5 million in annual sales if a company is a C-corp or has C-corp as a partner.
As you’ve just read, there are pros and cons to both the cash and accrual basis methods of accounting. To avoid any pitfalls with your accounting, and to avoid getting in trouble with the IRS, it is best to go over all your circumstances with your accountant. Your accountant can also ensure you are adhering to any new guidelines or laws that may impact how you handle your legal accounting. If you need help choosing the best accounting method for your firm contact us, and we would be happy to set up a consultation with you.