Should you use cash accounting or accrual accounting when running your own business? What’s the difference between the two methods? What are the pros and cons? If you’re feeling a little overwhelmed by all this accounting jargon, you’ve come to the right place. Sit back, relax, and take some time to read Zervant’s beginner’s guide on what exactly cash-based and accrual accounting are, and how to decide on the best option.
The Main Difference Between Cash and Accrual Accounting
Both of these methods are useful ways of doing the books in your business, but for very different reasons. The main difference between them simply comes down to how you record business transactions.
Let’s start with a quick overview.
With cash accounting you record all business transactions (on your profit and loss statement) based on when money physically changes hands. Any payments you receive are only recorded once the money is sat in your bank account. And anything your business pays for – products, services, etc – is only logged once the money has left your account.
“Think of it as a real-time tracker of the flow of money in and out of your business.
Sounds pretty logical, right? Well, it’s a great method to use if you’re just starting out. It’s simple, straightforward and great for keeping an eye on cash flow. Plus from a tax perspective you only need to declare money as and when it comes into your business.
BUT there are also drawbacks. Cash-based accounting does little to match revenue with expenses (more on this below). You also need to be aware of the restrictions on who can use this method.
This differs to accrual accounting. Here you record all business transactions on your profit and loss statement as and when they take place, regardless of what money is where. For example, you’d record the money for an invoice in your accounts based on the due date, even if your client doesn’t pay on time.
Confused? Let’s Look at an Example
Imagine you own a bike shop, and you’re using cash-based accounting. In August you buy some bike accessories from a local workshop, worth a total of £1,000. You plan to sell all the accessories in August too. Things don’t quite go to plan, but you do sell everything in September instead, for £1,500 (the extra £500 being your markup).
This means that on your profit and loss statement you’ll record a £1,000 loss in August (when you bought the accessories), and a £1,500 profit in September (when you sold them).
This is where your problem starts with cash-based accounting!
Because your business is now showing as having been deep in the red in August, and then having suddenly leapt into the black in September. But, in reality, during these 2 months your business had £1,000 worth of expenses, £1,500 worth of revenue, and £500 profit.
Cash-based accounting can give misleading figures on how your business is doing. Which is not ideal when talking to the bank about a loan, assessing performance, or in fact anything even slightly complicated.
Which is where accrual accounting comes in.
The Same Example (but with Accrual Accounting)
Remember that with this method you record all the money going in and out of your business on your profit and loss statement as and when these transactions take place. Regardless of whether you physically receive payment or not.
Back to the bike shop, but this time we will use accrual accounting.
The bike accessories were bought in August, for £1,000. They were bought on credit, to avoid any holes in your company accounts, or running out of cash. And as it’s uncertain when they’ll be sold, this £1,000 will be recorded in an accounts payable account (an account for money owed by a business to its creditors).
Likewise, when the accessories are sold, there’s no guarantee they’ll be paid for straightaway. So the £1,500 will be entered in an accounts receivable account (a more concise way of saying the money that your business is owed by customers, for goods provided or services rendered, but which have yet to be paid for).
As you can see, this method is more complicated, and requires several accounts. So WHY ALL THE FUSS?
Accrual accounting gives much greater insight into a business’ economic performance and financial health. It also ensures your business’ financial status isn’t damaged by things like late payments. And you get a much more complete picture of how a business is doing in the long-term, rather than monthly peaks and troughs (known as the matching principle in accounting jargon).
“Accrual accounting is more CONSISTENT and ORGANISED. 2 adjectives you definitely want to use when describing your business finances!
BUT, as ever, there are a few catches. You get no insight into cash flow. And as you only record when transactions take place, not when you actually receive the money, your business numbers might look great on paper even if there’s no money in the bank!
So… What’s the Best Way to Do Your Accounting!??
Hopefully you’ve now got a bit of a better understanding of the difference cash and accrual accounting. But how do you decide on the best method for your business?
Well, cash-based accounting is great for getting started. Or if you’re a very small business with limited stock and limited entries to record in the books. It’s simple, straightforward and requires minimal effort.
But if you’re planning to grow you’re going to need to switch over to accrual accounting at some point. It’s a must if you’re after funding, loans or investment. This is a statement about how you run your business, and what your plans for the future are. It’s the best method to manage more complex business operations.
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