Law firms work hard for their clients, often putting in hours and hours of labor before the case is complete. Attorneys may even pay up front costs for clients, and have to wait to be reimbursed for several months. Because of this delay between the work and the income, many attorneys run their business on a cash-basis accounting system. But what are the other options, and might there be a better method? The three methods of accounting, Cash Basis, Accrual Basis, and Modified Cash Basis, all have pros and cons. Looking at each method will help any law firm to decide which one is the best.
Cash Basis
The cash basis method of accounting means that when money comes in, it is recorded on that day. If a client case finished up in January, but the client does not pay his fees until March, the income is recorded in March. The same goes for expenses – whenever the expense is actually paid determines when it is recorded in the books. That means that if a law firm pays office rent on August 1st for August, then again on August 31st for September, the books show two rent payments for the month of August, and no rent expense at all for September.
This method is a very simple, straightforward way of record-keeping, and tends to be the method of choice for attorneys. Due to the long delay between work and income, most attorneys opt for the cash-basis method to help keep track of how much money is available for draws or other expenses.
Obviously, cash basis is easy to record, but can make the big picture look a little confusing. Diligent attorneys should want to know how the firm is doing from month to month. Was January a good month? Were a lot of expenses created in certain months, but not many in others? Or perhaps several expenses simply occurred in a month due to good cash flow. Cash basis reports can make those questions a little difficult.
Perhaps the biggest reason that attorneys use cash basis is to help with taxes. When using cash basis, businesses are not required to pay taxes on income that has not reached the bank yet. So, all the work performed in November and December each year may not even be taxed for an entire year. If the law office bills clients in January for work done late in the year, it can avoid a few months’ worth of taxes. If at the end of the year the law firm has enough cash to prepay some January expenses, it can do so in order to lower the tax bill for the next year. Cash basis reporting can be a very good thing, especially if the firm is operating on a slim margin.
Accrual Basis
Accrual basis can be a little complex. When income or expenses are billed, they are immediately recorded in the books. The records do not show when money comes in or goes out, just when it was originally billed. For example, a client asks an attorney to review his new business paperwork on August 17th, and an agreement is created for $XXX. The bookkeeping will show that income was earned on August 17th, even if the money does not arrive until September. In the same method, any expense that the law firm incurs during August will be recorded in August, no matter what the payment terms may be.
Accrual basis accounting gives a very clear picture of the business from month to month, helps law firms create budgets, and makes the business more eligible for loans. The generally accepted accounting principles (GAAP) in the USA states that the accrual method is the most accurate way of keeping financial records.
However, accrual basis can also have drawbacks. Recording income before it arrives causes problems at times. If an attorney needs to make a payroll draw, she or he could have trouble determining how much money is available to draw from. Yes, technically, the firm grossed a large profit in August, but did the money arrive in the bank account yet? One little slip in interpreting the financial reports could cause an overdraft.
Another problem arises at tax-time – law firms operating on accrual basis will have to pay taxes on all the income they earned the previous year, regardless of how much of that income has actually been received. This may be the biggest reason most smaller firms opt for cash basis instead.
Hybrid method: Modified Cash Basis
Some attorneys have found the perfect middle ground when it comes to their accounting method – the modified cash-basis method. In this method, most of the bookkeeping is done using cash basis, but long-term expenses are still recorded using accrual basis, in order to correctly record depreciation and amortization. This option is only good for internal records, but could be a great way to keep track of the business between tax filings and loan applications.
Another middle ground solution could be keeping the books on accrual basis, then running the reports for the taxes on a cash basis. This way the tax breaks are captured, and the firm’s real expenses and income is still easy to see each month.
Whichever method a law firm decides to use, it must stick with that method for the entirety of the practice, unless permission can be obtained from the IRS to change accounting methods. Each method has advantages and drawbacks, so it is worth a discussion with a good CPA and bookkeeper to determine the best choice.
