When most people start a small business, they suddenly find they need to learn accounting skills.
This isn’t necessarily difficult, and there are two primary accounting methods: cash basis and accrual accounting.
Read on to learn more about these vital areas of business admin.
Here’s what we cover:
- Cash basis versus accrual accounting: An overview
- What is accrual accounting?
- What is cash basis accounting?
- Accounting method: Cash basis or accrual?
- Can you change from cash basis to accrual accounting?
- Final thoughts on cash basis and accrual accounting
Cash basis versus accrual accounting: An overview
The difference between cash basis and accrual accounting comes down to the time at which your expenses and income are officially recognised:
- Cash basis accounting (also known as cash-basis accounting) immediately recognises revenue income and cost as it occurs. This means recording inbound and outbound transactions as they happen.
- Accrual accounting acknowledges income and expense in lieu of cash actually moving. An example of this is recording purchase orders and invoices.
Cash basis and accrual accounting each have their pros and cons.
What type of accounting you choose could define the success of your business. For example, you get a better picture of your finances and also of any arising opportunities by using accrual accounting.
But cash basis accounting is simpler, so will eat less of your time.
What is accrual accounting?
With accrual accounting, revenue is accounted for at the point when it’s earned. Expenses are accounted for when they’re incurred.
It doesn’t matter if money has actually changed hands or not. We just assume it will at some future date. And this is the key difference compared to cash basis accounting.
Expense example for accrual accounting
Smith & Co buys £1,000 of raw materials from a supplier.
At the end of the financial period, the finance team enters data for all the company’s purchases and use the date on the invoice they received to record the £1,000 expense in the accounts payable part of the accounting software.
They do this even though they don’t expect to pay the £1,000 for a month, as per the agreed terms.
The £1,000 debt is recorded as a liability in the company accounts.
Revenue example for accrual accounting
Smith & Co uses the raw materials to create widgets, which it sells for £3,000 to another company.
The finance team issues an invoice for £3,000 and uses the date of the invoice to account for the transaction in the accounts receivable part of the accounting software.
This is even though they know the terms agreed with the customer are that they will not receive the £3,000 payment until the next financial period (e.g. next month).
The £3,000 sale is recorded as an asset in the company accounts.
If the managing director of Smith & Co looks at her profit and loss statement, she will see the £1,000 debt for the raw materials alongside the £3,000 sale.
Therefore, she can see at a glance how well her business is doing.
Advantages of accrual accounting
The main benefits of using accrual accounting are:
- You have a more accurate view of your company’s financial standing, which allows you to forecast for the future and make strategic financial decisions.
- Your company’s financial profile won’t be unfairly judged against late payments or payment lag.
- A clearer depiction of a company’s financial state is more attractive to investors who could help your business grow.
- It’s a GAAP compliant accounting system, which you will need to adopt if your business grows.
Disadvantages of accrual accounting
The main disadvantages of using accrual accounting are:
- It can be notoriously difficult to change over from a cash basis to accrual system.
- Doesn’t give you an accurate picture when it comes to cash flow.
- Slightly more complex to track because you aren’t just tracking cash in and out. Accrual is more resource intensive since this system tracks accounts receivable and accounts payable.
What is cash basis accounting?
With cash basis accounting, you only need to consider money at the time it comes into or goes out of your business—when you get paid, or when you make a payment.
This can be confusing, so here’s how to do cash basis accounting.
Smith Decorators puts up some wallpaper for a client and sends an invoice. However, it doesn’t receive payment for 30 days, as per its agreed credit terms.
With cash basis accounting, the income for the work only enters its books when it actually gets that money via a bank transfer a month later.
Similarly, Smith Decorators might receive an invoice for the wallpaper it bought.
It only accounts for that invoice at the point it makes the payment—when the money left its bank account via a debit card payment at the wholesaler, for example.
That could be a month or two before it even uses the wallpaper at a client’s premises.
Advantages of cash basis accounting
A cash basis accounting system has many benefits:
- It’s straightforward to manage because you are tracking cash in, and cash out from a single-entry ledger.
- It gives a good indication as to how much money you have at any given moment.
- You can lower your tax liability by controlling the timing of expenses in relation to income since income is only taxable when you’ve received it.
Disadvantages of cash basis accounting
While cash basis accounting is simple and easy to manage, it can come with some downsides:
- Cash basis accounting doesn’t show business liabilities so in effect, there’s no way of telling how much of the cash that you currently hold can be spent.
- Not all businesses can use cash-based accounting especially if you sell services and products on credit.
- It’s difficult to understand a company’s financial potential because you can’t see the reasons behind profitability by just measuring cash as there is no context.
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Accounting method: Cash basis or accrual?
Accrual accounting versus cash basis accounting—which kind of accounting should your business use?
The question might be answered by the size of your business. In the UK, you’re only allowed to use cash basis accounting if the following applies:
- You’re a sole trader or self-employed business (or partnership). It can’t be used by a limited company.
- Your turnover is less than £150,000.
Accountants are happy to explain why accrual accounting is better than cash basis, but are also happy to recommend the simpler cash basis accounting system for their clients—especially sole traders, to whom admin work such accounting can sometimes be an afterthought.
So, let’s answer that question: why is accrual accounting better than cash basis accounting?
Accrual accounting brings with it flexibility.
For example, you can offset losses against previous years, or against other income. You can claim tax relief on bad debts (that is, debts that never get paid).
And if your business holds lots of stock (if you’re a retailer, for example) then accrual accounting is best because it’s easier to account for such assets.
It’s also hard to get business financing if you’re using cash basis accounting because it’s difficult to see the financial health of the company.
On the surface, cash basis accounting makes a lot of sense, especially if you’re new to running a business.
It’s nice and simple.
The cons are that it can be hard to match income to expenditure, so it can be tricky to see how well the business is actually doing.
And there’s no way to get a here-and-now view of sales versus expenditure.
Can you change from cash basis to accrual accounting?
To use cash basis accounting, you need to tell HMRC on your Self Assessment tax return. If you don’t, HMRC will assume you’re using accrual accounting.
If you’re aiming for business growth, there will be a time when you will be required to adopt accrual accounting.
Therefore, starting out as you mean to go on by adopting accrual accounting is probably best.
But, yes, it’s possible to switch from cash basis to accrual accounting.
Converting from cash basis accounting to accrual accounting can be like changing the wheels on a car while it’s still in motion. Nonetheless, many businesses do so every year out of necessity.
The following tips might help:
- Read up on accrual accounting so you fully understand what’s required. There are many beginner guides and books available.
- Read up on how to make the switch from cash basis to accrual accounting. The process is likely to involve a wholesale overview of your recent sales and purchases, as well as identifying things such as assets. Unless you’re very brave, it’ll probably be essential to get the help of a financial professional, such as an accountant.
- Accounting software can help create the foundations for good accrual accounting. If you haven’t yet started to use accounting software then the point at which you switch to accrual accounting is an excellent time to do so.
- Switch at the right time. Because accrual accounting places much more importance around financial periods, it makes sense to make the switch during a natural break—such as the tax year-end.
Final thoughts on cash basis and accrual accounting
So now you know the difference between cash basis versus accrual accounting, it should be a bit clearer for you as to which accounting method you should use for your business.
However, if you need further support, it’s worth speaking to an accountant to determine which option is best for your business.
Getting an expert view in this area can really help your business with the management of your accounts.
Editor’s note: This article was first published in June 2021 and has been updated for relevance.
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