Cash vs. accrual accounting is one of the choices you have to make regarding company taxes and thus you need to be aware of the pros and cons to each method. Arbitrue has put together a quick guide to help you decide whether cash or accrual method is a good fit for your business.
Cash vs. accrual: Basic definitions
Both cash and accrual relate to the date when a company must record income in accounting records. You’ve probably seen these words flying around, but what do they mean?
Cash basis method
With the cash basis method, income for a business is recorded as payment arrives and business expenses are recorded as they’re paid. Cash basis ignores any accounts receivable or payable i.e. any outstanding bills or payments. This method is intuitive and simple to implement.
The accrual method records money when it is billed and earned, regardless of when the money actually arrives in your account. This means you might have to record income before you actually physically receive the money. This method is a little more nuanced but is great for providing a holistic view of your company finances.
To better understand the differences between cash and accrual, let’s take a look at an example:
You invoice a client for $1,000 on May 15. The client has 30 days to pay the invoice and ends up paying on June 1. You receive money in your account on June 2. Do you record the income in May or June?
- Under the cash method, you would record $1,000 in June’s books, since this is when the client paid.
- Under the accrual method, you would record $1,000 in May’s books, since this is when the transaction took place.
What are the pros and cons?
The cash method is a popular choice for small businesses, particularly because it is simple to use and easy to maintain. It’s intuitive since it is a real-time recording of when money enters and leaves your bank account.
One of the downsides to using the cash basis of accounting is that it can produce an inaccurate picture of your company’s longer-term cash flow. Many clients and companies take a month or more to fully clear payments.
For example, you may be fooled into thinking you have a large volume of income for the month when actually the cash-flow is as a result of last month’s work.
The other option, the accrual method, is a popular choice for many medium to large businesses which explains why it’s often referred to as the traditional method of accounting. The accrual method is good because it provides a comprehensive picture of how the business is doing at any given point in time, and where it might be headed in the future.
A drawback of the accrual method is that it doesn’t take into account funds that are actually available in your account. It records all accounts payable and receivable and therefore is not good at indicating bank balances. While your income statement may show a large amount of revenue, your bank account balance may be completely empty.
Additional factors to consider
- Yearly turnover
It’s important to take into account HMRC’s requirements when choosing which method to use. If your business has a turnover of greater than £150,000.00 per year then it’s no longer a choice: you must use the accrual method.
If the company reaches the 150,000.00 threshold during the year it can stay in the cash basis scheme until the end of the year and switch to accrual during the next year.
- Business type
Moreover, some businesses can’t use the cash basis method. For example, limited companies and limited liability partnerships, or even waste disposal businesses must choose the accrual method instead. Read the full list of business types allowed to use the cash method.
- VAT registration
If you’re VAT-registered, take care when deciding which method you choose. If your invoices are particularly high value and you have long credit terms, your business may prefer the cash accounting scheme because you can defer VAT payments until you physically receive payment.
- The timing of sales and payments
If your invoices are paid at the point of sale (POS), the accrual method may be better for you because it allows you to gain income, and thus reclaim VAT, as soon as possible. Understanding the timing of your sales is key to choosing an appropriate accounting method.
So which method is better?
Companies who meet requirements listed earlier are free to choose between cash and accrual methods of accounting. In their case, it’s more of a matter of personal preference. It makes sense to request advice from your accountant based on your specific business characteristics, such as the type of clients, funding sources, as well as goods and services sold.
It is common that businesses start off with the cash method because of its simplicity, and then switch to the accrual method as they grow, because it allows for deeper analysis of a business’s finances. In many cases, they’re forced to switch from cash to accrual due to changing from sole trader to limited company, or because of the increasing yearly turnover.