If you had never heard of the two terms cash accounts or accruals accounting you would be forgiven.
I feel there is a lot of terms within business and accounting that a lot of people are not familiar with, but it is not something that we are ever really taught is it?
Unless you studied business or accounting there is not a high chance that you would have come across it.
So, we want to help with that, and this topic seems a great place to start. Why? Mainly because it will affect every business and the pros and the cons to both methods are something to consider.
So, let’s start with a break down of the two.
These two methods are:
Cash Accounting. Cash Accounting is where you record the income or an expense at the time of paying or receiving it.
Accruals Accounting is where you record the income or expense at the time you raise the invoice or the date of the bill. This is also known as the tax point or tax date.
What are the common misconceptions?
Although the name suggests that cash accounting has something to do with the way in which you take the payment, aka cash, it does not at all. It includes any form of payment.
The low down on cash accounting.
So what should you choose? What are the pros and cons?
Let’s start with the easier one of the two, cash accounting…
Well, cash accounting shows you more about the money you have in the account however is not a great representation of cash flow, due to the fact you may have a high amount in your account, but that is only because you have not accounted for upcoming bills that you have not yet paid.
This can cause fundamental issues if you are trying to make key business decisions based on this information. When you looking at the business as a whole and if you are trying to get an idea of a forecast for the business you are only going to be able to see such a small portion of it.
Another pro, however, is that it is an easier option for when it comes to calculating tax. There is, of course, a con to this pro: not all businesses can use it and there are some limitations. For example, you can use the cash basis if you ' run a small self-employed business, for example, a sole trader, partnership or limited company and have a turnover of £150,000 or less a year’. A limitation to this is if you have another business the cash basis must be used for this business too, and that £150,000 limit must be a combined turnover from both of your businesses.
The low down on accrual accounting.
So naturally, that leads us on to accrual accounting.
Like I said a business that uses this accrual accounting method incorporates the outgoing and income before they have even happened.
So whether that is an invoice that has been raised or a bill that has been received it is treated like that even if the money has not been received or sent yet.
Which means you naturally have a lot more of a clearer view of your business, which helps you to make more strategic decisions with confidence. This method is also more favourable if you are trying to get funding or investment, investors will want to see the bigger picture.
So it sounds like accruals is the way to go, right?
Well, there are some cons to consider. You do get a better view of your business but you need to be on top of your invoices and the bank.
But this is where a good app stack can really come into play, of course, we talk a lot about Xero and Receipt Bank as they can take much of this stress and confusion away.
You can even get it so that they sync together. If you want to talk about this more, or would like to talk about how we can help with this you can contact us here.
In some cases, you can also end up paying tax on income that you may not have received yet. This is why cash flow is so essential. Looking into a system such as GoCardless that syncs with many accounting software, including Xero can help.
So where does that leave you?
This should give you an idea of the two.
But you can use a hybrid of the two. Some businesses do a blend of them both; making key decisions on the accruals basis but manage tax based on a cash basis.
So, for example, they may base their year-end accounts or working out if they have the cash flow to hire on a accruals basis and work out their VAT on a cash basis.
We hope this has cleared it up for you.
We recommend reaching out to your accountant to see what is best for you. If you would like to chat with us you can contact us here, or alternatively, check out our Instagram.