It’s possible that if you are a small business owner without a lot of accounting knowledge, you will already be using cash or accruals basis for your accounting without actually understanding what this means. If this is the case, there might be a better option for you, and this article looks to help you to make that decision.
So what is meant by these terms?
The difference between cash and accruals basis is basically timing, revolving around when you record your revenue and expenses. If you do it when you pay or receive money, then you are using cash basis accounting. If you do it when you raise an invoice or receive a bill, you are using accrual basis accounting.
Cash Basis Accounting
Cash basis accounting means that businesses do not recognise income until money has changed hands – and the same for expenses. Sent invoices are not considered income until the invoice has been paid and will only be recorded at this point.
What Are The Benefits Of Cash Accounting?
- It makes it easier to calculate tax (if your business is allowed to use it – you should check the HMRC website to find out more)
- It is a simpler process that shows you the exact amount of money you have available.
What Are The Downsides Of Cash Accounting?
- It is more likely to be inaccurate. You may see that you have a lot of money available but only because your bills have not yet been paid.
- It only offers a day-to-day view of your business’s financial health, which isn’t helpful for business planning.
Accrual Basis Accounting
Businesses that use accrual accounting record income and expenditure as soon as it is made (i.e., as soon as an invoice is raised and sent to a customer). This means that records reflect the overall financial health of the business, over a longer time period.
What Are The Benefits Of Accrual Accounting?
- You have a more accurate overview of your finances that covers a longer time period
- You can use your financial records to make more confident business decisions
- It carries more weight with investors
What Are The Downsides Of Accrual Accounting?
- It can be more time and labour-intensive as you need to pay attention to bills and invoices rather than just your bank account.
- Sometimes you may have to pay tax on invoices before you have been paid for them.
How Does This Affect Business?
As mentioned before, the main difference between cash and accrual basis accounting is timing. Accrual basis accounting is generally considered the better long-term accounting method, as it offers a more rounded overview of the financial health of a business. However, for smaller businesses this can also cause problems.
In this case it is paying tax that is the issue. From a tax perspective, if you have reported income that you have not yet actually received, you will still have to pay that tax at the end of the tax year regardless. If you then don’t receive this income at all, you have to wait until it is time to fill out your next tax return before you can get this money back. For businesses with very tight incomes, this can cause real difficulties.
Another difference between the two types of accounting is that, whilst accruals basis accounting is suitable for everyone, cash basis accounting does carry some restrictions.
There are specific rules regarding who can use cash basis accounting, and these are likely to affect:
- More complex businesses (for example, those who carry high levels of stock)
- Businesses who want to claim interest or bank charges of more than £500 as an expense
- Businesses who are still looking to get finance
- Businesses who have losses that they want to offset against other taxable income
Cash and accrual basis accounting are not the only options available to businesses. Some businesses prefer to use a hybrid accounting system to manage their finances, as this works better for their financial and reporting needs. In these cases, a business might use cash basis accounting in order to simplify their tax processes but use accrual basis accounting in order to make big financial decisions and apply for finance.
Whilst this may seem like the best option for any business, there are lots of rules and restrictions regarding who can use a hybrid accounting system, so it is worth speaking with an accountant before deciding to use this method.
Cash Vs Accrual Vs Hybrid Accounting
So what is the best option for you and your business? This will entirely depend on your goals and the way you run your business. For businesses who want to pay close attention to their overall health and performance, accrual accounting offers the best indication of how a business is doing financially.
It is rare for a business to use cash accounting alone, unless they have just started out and are still building their accounts. Cash accounting will help you to keep an eye on your cash flow, but is not a great option long-term, as the business grows. Hybrid accounting offers larger businesses the chance to regulate their funds for tax purposes, with the opportunity to plan better for the future.
Whilst all of this may seem complicated, it is really not in today’s technologically advanced world, with various software systems available to help you to manage your accounts. All you need to do with accrual accounting, for example, is set up your software to read your bills and invoices, and then these will be recorded as income and expenditure automatically. For those who choose a hybrid method, some software can even be set up that will switch between cash and accrual as and when needed.
Most importantly, before you make a big decision such as this, it is critical that you speak with a financial adviser who can work with you to decide which method is best for your business, and even help you switch to a new accounting system as your needs and business processes change.
Choosing, or changing, which accounting method you use is a decision that should not be taken lightly. If you are set on this course of action, it is typically easier to do it at the start of your next financial year, as in essence you can start from a clean slate. Making the change inbetween years raises added difficulties in that you have to carefully manage the transition so as not to cause account balances in your financial software from becoming incorrect, not an easy task!
Why not contact the team at TFMC on 0800 470 4820 or email [email protected], if you require help and advice on the issues raised in this article, or if you have any other accounting needs.