Should my firm use accrual or cash basis accounting?
There are two methods law firms can run their accounting by: accrual basis or cash basis.
The primary difference between the two is the point at which revenue is realized. In cash basis accounting, revenue is recognized once the payment is received. In accrual basis accounting, revenue is realized when the sale is made even if the payment isn’t complete.
It can be difficult to see the current status of the firm’s financial health with accrual basis accounting, but it does help to show an overall picture over time. This makes it easier to plan for strategic decisions and plan for budgets based on expenses, staffing, and sales.
It can be difficult to determine the true state of your account balances, especially if payment terms are longer than net 30. With accrual accounting, revenue is recorded when it’s earned, even if a payment isn’t made. This means you could invoice $150,000 that is immediately recognized, but not receive payment for thirty days or more. During the time you’re waiting to be paid, those funds still show are being counted as revenue for your firm which can be misleading.
The tax disadvantages associated with accrual basis accounting are one of the primary reasons many firms opt for cash basis. With accrual accounting, invoiced items for services completed before the end of December in one year will be counted as part of the tax considerations for that year, even if payment isn’t made until the following year. To account for this, many accountants will conduct an accrual-to-cash conversion to address the issue.
Cash basis accounting provides a clearer picture of what your current cash flow situation looks like. Payments are only shown once they are actually received and not when the services are completed, as they are with accrual accounting. As a result, you can more accurately see what income the firm is realizing.
Cash basis accounting can be misleading when it comes to monthly performance. The numbers may reflect highly one month, and this could be due to clients paying past due invoices rather than received payments for work completed that month. Cash basis accounting is not always an accurate depictor of sales realized in a particular time frame.
Additionally, there are restrictions imposed by the IRS as to the accounting method that can be chosen depending on the amount of annual sales2. An accountant can help you determine which of these two methods is most appropriate for your firm.