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Cash vs accrual accounting – which should you choose for your business? Before you can answer that properly, you’ll need to know exactly what the accrual accounting method and the cash method of accounting are and what the advantages and disadvantages are of the two different approaches to financial recordkeeping.
In this article, Black And White Accounting will explain:
- what the accrual method of accounting is;
- what the cash method of accounting is;
- the advantages and disadvantages of accrual accounting;
- the advantages and disadvantages of cash accounting;
- recording transactions in cash and accrual accounting; and
- real world examples of cash and accrual accounting and their consequences.
To speak to us about both the accrual and the cash accounting methods and which is better for your business, please call Black And White Accounting on 0800 140 464 or click here to email us.
The difference between cash and accrual accounting – the simplest explanation
In a nutshell, the difference between cash and accrual accounting is when your business’ revenues and expenses are “recognised”.
With the cash accounting method, revenues and expenses are recognised when money changes hands between you and your client or supplier – in other words, when the cash hits your bank account or your supplier’s bank account.
With the accrual accounting method, revenue and expenses are recognised when a transaction takes place – the date on which a client agrees to buy from you or you agree to buy from your supplier.
So, with accrual accounting, it doesn’t matter when you pay the bill to your supplier or your client pays the bill to you. It’s all about the date you bought something or somebody bought something from you or not when payment arrives in the other person’s bank account.
What does it mean to record transactions?
When you record a transaction in bookkeeping, you add it to your business’ “ledger”. What’s on your ledger shows how much profit you make in a year and how much income tax and National Insurance you need to pay to HMRC.
What is cash basis accounting?
If you choose cash accounting (sometimes called the cash method or cash basis accounting) like most small business owners do, the good news is that it is very straightforward and much less complicated than the alternative.
So what are the other pros and cons of the cash method?
Advantages of cash basis accounting
With this accounting approach, you really only keep track of when money comes into and goes out of your bank account.
There are certain points towards the end of your VAT quarters and the financial year (if you’re self employed) where using cash accounting means that you actually pay less in taxes although the saving you make is only deferred.
That’s because you don’t pay taxes on invoices you’ve issued – you only pay taxes on invoices after you get paid. We’ll show you how this works later on in the article.
Disadvantages of cash basis accounting
Two of the most important bookkeeping statistics in any business large or small are “accounts receivable” and “accounts payables”.
Your “accounts receivable” records show you the money you’re expecting in and “accounts payable” records show you the money you have to pay out to your suppliers.
Small business owners using cash accounting often don’t keep as close track on the money which is due in and due out as they should because their only way of measuring success or failure is judged by the cash in their bank account.
How is this a disadvantage? You may make £20,000 worth of sales in one month but only record £10,000 worth of revenue because that’s the actual cash you received into your bank account. The level of real profit you’ve made will therefore be understated.
Likewise, let’s say that you bill £20,000 revenue in one month and you receive all the money from your clients but you are also sent £40,000 worth of bills from your suppliers in that same month but you don’t intend to pay those bills until the following month.
In this case, it may look like you’ve made a large profit when you’ve actually made a loss.
With this accounting method, you never really get an accurate picture of the financial health of your business and it’s much harder to know how well your business is actually doing.
And it’s because your financial situation will be opaque to others that you’ll find it hard to raise cash for expansion or to spend on plant and machinery to grow your business if you present these types of accounts to a funder or investor.
What is accrual accounting?
Accrual accounting (sometimes called the accrual method or accrual basis accounting) is the more common approach to accounting used by companies.
With accrual accounting, you record your income/revenue and expenses at the time the sale is made regardless of whether you have received money from your client or your supplier has received money from you.
So what are the main pros and cons of choosing to use the accrual method?
Advantages of accrual basis accounting
Accrual accounting presents you with a much clearer vision of how your company is performing both over the long-term and historically because of its accuracy in recording the dates you sent out invoices and you received invoices from your suppliers.
This recordkeeping means that you’re able to track income and expenditure accurately so that you can compare turnover and profitability on a month by month basis.
Another significant advantage will be your ability to manage your accounts receivables better.
You’ll be able to check your accounts receivable records to determine how quickly individual clients pay you and manage your cashflow better.
You’ll get to understand each clients’ payment cycles and this knowledge will allow you to make better decisions on how much credit you extend to individual customers based upon how quickly they historically have settled your invoices.
Disadvantages of accrual basis accounting
The accruals method is more complicated than the cash method and you will need to spend more time on your bookkeeping.
This method is also not as focused on cashflow so you could find yourself in the situation where your financial records are showing your company as having significant and profitable income despite the fact that there might be little or no money in your bank account.
There will also likely be certain points in the year when you pay taxes on money you’ve not received when you use the accrual method.
Cash vs accrual accounting – real world example
As we’ve seen, revenue/income and expenses are recorded differently depending on whether you use the cash basis or accrual basis of accounting for your company.
Let’s have a look at an example and what it might mean for small business owners.
Record of revenues – example
Let’s say that Pete runs a training company and he provided a health and safety training course to a client on 10th March for £1,000 + VAT (£1,200 including VAT). He issues the invoice on the same day but his client doesn’t pay him until the 28th April.
With cash basis accounting, Pete would record the sale into his bookkeeping package on 28th April, the day on which he was paid.
With accrual basis accounting, Pete would have recorded the sale on the 10th March, the day he carried out the work and issued the invoice from his bookkeeping software.
Record of expenses – example
Let’s say that, in order to be able to provide that health and safety training course, Pete needed to purchase an overhead projector.
He bought it from his supplier on 4th March for £500 + VAT (£600 including VAT) and he waited until he got paid from his client before paying his supplier. This means that Pete made payment to his supplier on the 28th April.
Using cash accounting where your revenue/income and expenses are booked on the day you get paid and the day you pay your suppliers, Pete would record this transaction on 28th April.
Using accrual accounting, your expenses are recorded when the deal is done meaning that he would log this transaction into his bookkeeping system on the 4th March upon receipt of the invoice from his supplier.
Income tax/VAT consequences – example
So, what are the consequences of using either of these accounting methods for Pete with respect to income tax and VAT?
Let’s say that March was the last month of Pete’s VAT quarter. If he were using the accrual method, he would have to record both transactions in his bookkeeping software as happening in the month of March and they would both be reflected in the VAT bill he pays in May.
However, by using cash accounting, both transactions would not be recorded until the month of April which is inside the following VAT quarter. This means that these transactions would be reflected in the VAT bill he pays in August. So that’s better for his cashflow.
What about income tax and National Insurance Class 4?
The financial year runs from the 6 April to the 5th April. If Pete were using the accrual method, both transactions would be caught in the current tax year and this would be reflected in his Self Assessment which is payable the following January.
However, if he were using the cash basis method, he would record both transactions in his bookkeeping software in the month of April in the following financial year. This means that these transactions would be reflected in the next Self Assessment form meaning any taxes due on it would be paid a year later than with the accrual method.
In essence, choosing between the accrual and cash basis methods has implications for the timing of tax payments in self-assessment. For individuals like Pete, understanding these nuances becomes crucial, and seeking guidance from a qualified self-assessment accountant can ensure optimal financial planning aligned with the chosen accounting approach.
As you can see from this example, the major benefit of cash accounting is its positive consequences for cash flow but you should not be solely persuaded by that fact to choose this method.
In fact, if your choice of this accounting method is purely the short term deferral of taxes, then you may need to ask wider questions about your business and its ability to manage money.
Cash vs accrual accounting Quick FAQ
Should a small business use cash or accrual accounting?
It depends on which one of these two accounting methods works better for your small business.
If you take payment at the point of order and the gap in time between getting the stock you require and selling it to end users is brief, accrual accounting would probably be better as it will give you a better indication of your businesses’ performance and there is no real cashflow advantage in this situation.
If your small business invoices clients and you give them an extended period of time upon completion of the job, there will almost certainly be cash flow advantages for you with the cash accounting method.
If your small business has “lumpy cash flow” where the payments you receive are generally large and do not occur regularly and where you invoice clients with 30+ days’ notice, there are distinct cash flow advantages to using cash accounting however it will be more difficult to measure at any given time the true performance of your business.
As you can see, this is a tough question to answer because of the number of variables involved.
You should discuss your priorities with your accountant prior to make a decision on which accounting method you select.
Can you use both cash and accrual accounting?
Yes and no.
Many small businesses use something called “hybrid accounting”. You can keep two sets of books – cash books and accrual books (although you only present one to the taxman).
Many small business owners use cash accounting for the purposes of minimising VAT in particular but they’ll use their accrual books to base big decisions on like whether their company has enough money to invest in new equipment or expand or whether they’ll have to borrow money instead.
Please note that sole traders and partners are permitted to use cash accounting for Self Assessment tax return purposes (with a few exceptions). Limited companies and limited liability partnerships can’t use the cash basis method for the assessment of their taxes.
Stay on the right track with accurate bookkeeping from Black and White
Black and White Accounting works with businesses using both accrual accounting and cash accounting methods – we have decades of collective experience in both and we look forward to sharing our knowledge and insights with you. Get in touch with us – tell us about your business and your plans for the coming 2-3 years.
We’ll let you know which is better for you now between cash and accrual accounting and, if it becomes more advantageous for you to switch your method of accounting, we’ll let you know and take the necessary actions.
To find out more about running a better business and paying less in taxes, please get in touch with us today, by contacting Black and White Chartered Certified Accountants, populating the “Got a Question” form on the right, or calling us on 0800 140 464.
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