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Understanding accrual basis accounting Exploring cash basis accounting Comparing accrual and cash basis accounting Hybrid accounting methods Choosing the right accounting method Conclusions on cash vs. accrual accounting
One of the first decisions business owners must make is what type of accounting method they’ll use to track their income and expenses. There are two main methods of accounting: accrual accounting and cash accounting. Both are useful in certain scenarios, although for larger businesses, tax authorities in some geographies generally require accrual accounting be used for filing taxes.
While you may have to pick one or the other for filing your taxes, you could use a hybrid method internally. The hybrid method combines cash and accrual accounting, with the exact combination tailored to your business’s needs.
Before you use any accounting method, however, it’s important to answer what the difference is between cash and accrual accounting. In this post, we’ll compare the different options so you have what you need to know to make the best decision for your business.
Understanding accrual basis accounting
In accrual accounting, you record revenue when it’s earned and expenses when they are incurred, not when cash changes hands. Your accounting, and the financial health of your business, is based on the economic events that affect your business rather than the movement of cash in and out of your business.
Let’s say you complete legal work for a client and invoice the client in January, but the client doesn’t pay until March. The income is still recorded in January, even though the client hasn’t yet paid.
Accrual accounting gives a more accurate picture of a business’s or law firm’s true financial health over a period of time. The business doesn’t suddenly look healthy because of a sudden influx of cash, or unhealthy because a large expense has been paid for. Rather, the long-term financial activities of the business are taken into account. It also makes financial reporting more consistent and easier to compare.
However, accrual accounting is more complex than cash basis accounting. It requires more bookkeeping and accounting knowledge to track income and expenses accurately. It also doesn’t give you a clear picture of the amount of cash you have on hand at any given moment.
Exploring cash basis accounting
With cash basis accounting, your revenue and expenses are recorded when cash is received or paid out, not when invoices are sent. All income and expenses are reflected in real-time when the money changes hands.
Using the above example, using the cash basis you would record the income in March, when the client pays your law firm, not in January when the invoice is sent.
The cash basis is simple and straightforward, especially for small business owners who don’t have a lot of inventory to record or other factors that can complicate their revenue. It also gives you a real-time view into the immediate cash you have available for spending.
However, the cash basis might not always give you a true picture of your financial health. This is because it doesn’t take into account your future financial obligations or potential income. It can also distort how profitable your business looks over time. If a client suddenly pays off a large invoice, you may have a lot of cash in your account, making your business look profitable. But if you have a large number of expenses that income has to cover, you’re not as profitable as you seem.
Not everyone is allowed to use cash basis accounting. The IRS (Internal Revenue Service), for instance, requires businesses that have average annual gross receipts of more than $26 million in sales in the prior three tax years typically must use accrual accounting. Additionally, certain industries are required to use accrual accounting.
Still, for some businesses, cash basis accounting is more regularly used. For example, it’s quite common to encounter many law firms using cash basis accounting, especially across the United States.
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Comparing accrual and cash basis accounting
The main difference between cash basis accounting versus accrual accounting is:
- Cash basis accounting focuses on cash flow into and out of your business; it tracks the transaction when it happens, not when invoices are sent.
- Accrual accounting focuses on the action that results in earning revenue or incurring an expense, not when the money changes hands.
If your law firm does not have long payment terms—that is, clients generally pay you immediately—the timing isn’t as much of an issue for your profitability. If you have long payment terms or have suppliers with long payment terms, then timing is a more significant issue.
Cash basis accounting tends to be best for:
Small businesses and sole-proprietorships: Small businesses that don’t have high revenue aren’t required to use accrual accounting. They are typically fine to use cash basis accounting.
Businesses that don’t have inventory: Inventory complicates revenue and expenses. If you don’t have inventory you purchase and then sell (for example, if you’re a professional services firm such as a law firm), you don’t have that additional complication. As a result, cash accounting might be more suitable.
Accrual accounting tends to be best for:
Large businesses: The IRS might require you to adhere to the accrual accounting method, depending on the size or type of your business.
Businesses with inventory or other complicated financial issues: If a significant portion of your business comes from selling goods you haven’t yet received payment for, or that you’ve already paid for but haven’t sold, accrual accounting gives a more accurate picture of your profitability.
Hybrid accounting methods
These days, businesses can use a hybrid method of accounting, which combines cash and accrual accounting based on the needs of the business. While you can’t file taxes using the hybrid method, you can use the hybrid method for internal tracking and recording.
For example, a small business or small law firm might use the cash basis of accounting for routine transactions such as sales transactions and bill payments. This simplifies the daily bookkeeping and gives a clear picture of cash flow and cash available at any given moment. The same business might use accrual accounting for inventory, which allows them to more accurately value their inventory and track their cost of goods sold.
When filing their taxes, the small business might use the cash basis, but use accrual accounting internally to track inventory, giving the owner a more complete picture of the business’s profitability. It can also be customized to each business’s needs. You can use the blend of cash and accrual accounting methods that works best for your business or law firm.
While the hybrid method does give a more complete picture of profitability, it is complex. Using the hybrid method requires careful management to ensure consistency in reporting and prevent duplication. It’s also vital to monitor your accounting or work with your accountant to ensure your business stays compliant when filing taxes.
Choosing the right accounting method
For law firms, the most important factor to consider when choosing the right accounting method is whether there are any industry or IRS regulations that require you to use the accrual method. If there are, then you must use it. Beyond that, if you choose to use a hybrid method internally, you may want to speak to an accountant to set up processes that enable proper application of the methods.
If there are no regulations that force you to use one method, then you can decide based on your circumstances. Factors to consider include:
Law firm size: Smaller law firms tend to prefer the simplicity of cash basis accounting. It is easier to maintain and track, and provides a clear picture of cash flow. Large firms may prefer (or be required) to use the accrual method. This considers earned but unpaid work and incurred but unpaid expenses.
Long-term goals: If you have plans to grow or expand your law firm, including taking on partners, accrual accounting enables you to predict future income and expenses, enabling better strategic decisions.
Revenue: Businesses with average annual gross receipts of more than $26 million in sales in the preceding three tax years must generally use the accrual method.
Conclusions on cash vs. accrual accounting
When comparing accrual accounting versus cash accounting, it’s important to keep in mind your law firm’s needs and circumstances. While many law firms prefer cash accounting because it aligns with their cash flow, accrual accounting might be better for larger firms that have large outstanding client fees. Additionally, depending on the size of your law firm, it may be mandatory to use accrual accounting.
With cash basis accounting, your income and expenses are recognized based on when you receive and make payments. It’s like keeping track of the money in your wallet. With accrual accounting, your income is recognized when you earn it, regardless of whether you’ve been paid. Your expenses are also recognized when you incur them, even if you haven’t paid them yet.
Whichever method of accounting you choose, its important to stay consistent in applying that method to ensure accuracy. If you’re ever unsure what to do, it’s always best to seek advice from an accountant.
Clio’s software helps law firms streamline many accounting and finance tasks, including trust accounting needs, and makes it easier for clients to pay you. Learn more about how Clio Manage makes it easier for you to run your law firm, or book a demo to see Clio’s trust accounting features in action today.
Disclaimer: This article is relevant to US practices. It is provided for informational purposes only, and does not constitute legal, business, or accounting advice.
We published this blog post in March 2024. Last updated: .
Categorized in: Accounting
