Dogs or cats? iPhone or Android? Cash or accrual? … huh?! It’s an age-old “this or that” question that you, as a legal professional and business owner, must address.
Which accounting method is right for my law firm?
To understand which accounting method best suits your law firm, you first have to understand the difference between the two options. To sum it up simply: the difference between cash and accrual accounting lies between when revenue and expenses are recognized. To further break that down: Accrual basis accounting recognizes revenue as soon as your services are billed even though you haven’t received payment yet, while cash basis accounting doesn’t realize revenue until payment has actually been received. Similarly, on the expense side of things, cash basis recognizes expenses when you pay them, while accrual basis recognizes expenses as they are incurred.
Cash Basis Accounting
It’s just easier. Recording income and expenses is straightforward. You simply need to follow the cash on your bank and credit card statements. Less time focusing on your business’s accounting means more time spent focusing on your clients.
Cash flow is clear-cut. Seeing as transactions are being recorded as they’re actually happening, it’s clear to see true balances and gives an accurate picture of how much cash you truly have to play with.
There’s more flexibility in terms of tax planning because you’re being taxed on the cash received, not the revenue earned.
Given that expenses and revenue are not recognized until cash is exchanged, there’s no A/R or A/P to maintain, which means that you don’t have a clear sense of what’s due to you or what’s owed.
It can be misleading. It only gives a limited look at your income and expenses and does not provide a clear indicator of how the business is doing and can make forecasting difficult.
Accrual Basis Accounting
- Accrual basis accounting provides deeper insight into a company’s profitability. This method allows you to see how much money has been earned and spent in a given time regardless of the fact that your invoices and your bills haven’t been paid.
- It makes budgeting and financial forecasting easier. With good bookkeeping, you can essentially always project what is on the road ahead of you in terms of income and expenses with accrual basis accounting.
- It’s complicated. While accrual basis’s sophistication is appealing, it requires maintaining accurate accounts payable, accounts receivable, prepaid expenses, and accrued expenses along with additional other items in order to get a full picture of the company’s profitability. Given these factors, accrual basis accounting can require a lot of time and resources that most business owners don’t have.
- Cash balances can be misrepresented because reporting reflects income for invoices that may not have been paid yet.
Get to the point! Which accounting method is right for my firm?
Unfortunately, the answer to this isn’t simple. When it comes down to it, the accounting method that you choose really depends on your business’s goals, size, and capacities. If you run a small law firm and are looking to keep things simple, then cash basis accounting is probably the choice for you. If you’re looking to expand your firm, however, accrual basis accounting is the way to go.
Can I combine the two and create an accounting method hybrid?
Eh, yes and no. The IRS requires that you choose an accounting method to file your annual taxes and it must remain consistent unless you want to go through the hassle of filing to change your accounting method with the IRS’s Form 3115. That being said, the rules are less stringent behind the doors of your own business. Let’s say that you are trying to understand your consistent monthly spend or are perhaps questioning which areas of your firm need additional support and potentially want to do some hiring - you can certainly manipulate your financial statements between cash and accrual to best inform your decisions.
Use your resources!
With the ever-changing tax rules and regulations, how can you be expected to know everything? (This isn’t a trick question, you can’t know everything.) Go ahead and use your resources – it’s what you’re paying them for! Ask your accountant/CPA questions about changing tax laws and how your accounting method will affect your tax liabilities. Ask your bookkeeper if they’re using your bookkeeping software’s functionality to its greatest extent so that you can get a full range of reports that help better inform you of your business’s financial health. Additionally, accounting software like QuickBooks Online has the functionality to switch reporting between cash and accrual basis at the click of a button, given that invoices and bills have been entered accurately.
At Practice Alchemy, we strive to be our clients’ greatest resource. Our law firm bookkeeping specialists empower and encourage our clients to understand exactly what they’re looking at in terms of reporting so that their base understanding of their company’s finances can further inform their decisions. If you’d like to learn more about how Practice Alchemy can help with your accounting and bookkeeping needs, request a consultation with our team.