What is the difference between cash-based and accrual-based accounting?
The difference between cash-based and accrual-based accounting is one of timing.In a cash-based accounting system, a law firm records income when it’s received and expenses when they are paid. In an accrual-based accounting system, a law firm records income when earned (invoiced) and expenses when incurred (upon receipt of the bill from the vendor).
This means that in a cash-based accounting system, accounts receivable (an asset account) and accounts payable (a liability account) are used to track amounts owed to and owed by the firm respectively, but they do not appear on the law firm’s balance sheet; and only the revenues (income) actually received, and the expenses actually paid appear on the law firm’s profit and loss (income) statement.
In an accrual-based accounting system, the accounts receivable and accounts payable are not only used to track the amounts owed to and owed by the firm, but they also appear as an asset account and a liability account, respectively, on the law firm’s balance sheet. Further, the accounts receivable appears on the law firm’s profit and loss statement as revenue (income) to the firm as soon as it is billed to the client, and the accounts payable appear as expenses as soon as a bill is received from a vendor.
In the United States, which accounting system your firm must use is determined by IRS rules, but generally law firms that make less than $5,000,000 a year use cash-based accounting. No matter which system your law firm uses, keep in mind each system has disadvantages and advantages that can affect your law firm’s analysis of its current profitability and future cash-flow.
In Canada, law firms are required to use accrual-based accounting systems. It is important for law firms to stay on top of all bookkeeping tasks and to reconcile the business accounts monthly to ensure that law firm administrators have the most accurate information about the firm’s finances. Having out-of-date financial data makes it harder for a firm to assess its financial health, and it could come back to haunt them in the event of an audit.