Cash or accrual basis accounting can be hard to wrap your head around but worry not as we’re here to help.
You might be asking: When do I use cash basis accounting, and when do I use accrual basis accounting?
The answer you may not want to hear is that it’s up to you as both methods are acceptable in accounting.
So, the question you should be asking yourself is which method is best for your business.
Before we delve in further, let’s first discuss the basics of transaction recording.
Identifying and analysing transactions
Keeping an accurate record of accounting transactions is vital in the operations of a business. The accounting cycle, which is 8 – 10 steps, begins with identifying the transactions that occur within the company.
Bookkeepers or accountants are tasked with identifying these transactions and examples of these include a sale, purchase or withdrawal. For example, a purchase of equipment from a vendor translates to a bookkeeping event.
Let’s keep with that example and record the purchase of equipment through credit. This results in a debit entry to equipment and a credit entry to accounts payable.
This transaction translates to the company obtaining equipment in exchange for credit, resulting in an entry in accounts payable. Once the vendor pays their dues, the accounts payable on this transaction reverts to zero.
How To Avoid Errors in Recording Transactions?
Erroneous transactions are common when directors and owners of a company are involved.
For example, the company chairman buys a personal car in cash with the help of a company employee. The event is not a company transaction but a private transaction of the chairman. Thus, recording such transactions into the company books may result in understating cash and overstating properties.
This step in the accounting cycle is crucial because knowing why, how and when a transaction was made will help bookkeepers properly account for the transactions and their impact on the company’s books.
Once you have identified and analysed your transactions, the next phase is recording these transactions into journal entries. Journal entry transactions come in the form of debits and credits and always equal 0.
There is a general misunderstanding that a debit means an addition, and credit means a deduction. That is not the case, as it depends on the type of transaction you are using.
Assets generally have a normal debit balance meaning any additions that are asset accounts are debited.
Liabilities and capital accounts typically have credit balances, so any additions to liabilities and capital accounts should be credited. Vice versa, any deductions to asset accounts must be credited; meanwhile, any deductions to liabilities and capital accounts must be debited.
Here is an example:
Company ABC entered into a bank loan agreement with DEF Bank for £500,000. Since Company ABC gained cash from the loan, the entry should be:
In this case, we received cash through a bank loan; therefore, we must debit cash. Our liability also increased in the form of a bank loan, thus a credit to the bank loan.
Ignoring interest, repayment of the bank loan in a lump sum would result in the following entries:
Here, the bank loan is fully paid. This means that there is a deduction in cash; therefore, cash is credited from our books. Because the loan is fully paid, we must debit the bank loan account to remove it from our records.
Recording transactions is where the cash vs accrual accounting methods will come in.
The idea of cash and accrual accounting boils down to the question:
At which point do I record and recognise my revenues and expenses?
The crux of the situation is: cash basis accounting recognises revenues and expenses when cash has been received and have left the company’s hands. On the other hand, an accrual basis recognises revenue and expenses the moment they occur, regardless of when they are paid or received.
Cash basis accounting
Cash basis accounting is simple.
Revenues are recorded when cash comes in, and expenses are recognised when money has left the company’s hands. Cash basis accounting recognises revenue and costs as the exact time and manner that cash moves in and out of business.
Transactions recorded on a cash basis can be considered less accurate than accrual accounting in the short term as they affect the company’s books when cash is received or paid out.
What if I receive the payment through cheque or other forms of payment other than cash?
It doesn’t matter.
Cash basis accounting doesn’t strictly limit itself to cash payment methods. Whether it be in the form of actual cash, regular cheque or manager’s cheque, the cash basis accounting is the payment process regardless of the payment method.
Accrual basis accounting
The accrual basis of accounting is the most used and practised method of recognising revenues and expenses across businesses worldwide.
Accrual accounting recognises income at the time it is earned and records expenses only when the liability is incurred regardless of the timeframe of when the cash was received or paid.
According to The Economic Times, “accrual refers to an entry made in the books of accounts related to the recording of revenue or expense paid without any exchange of cash.”
Suppose a sale was made on October 1, 2021, with a customer payment due date of 30 days upon receipt of the invoice. This transaction was already recognised as a sale or revenue on the company’s part when the transaction occurred. Thus, the company should record an increase in revenue and a corresponding receivable to pertain to the amount due from the customer within 30 days.
This accrual accounting method stays true to the matching principle. Under the matching principle, the recording of revenues and expenses happen as they occur, regardless of when they are paid.
Matching Principle Example
Company ABC uses accrual accounting, and Company DEF uses cash basis accounting.
Under the cash basis accounting, Company DEF had sales of £1,000,000, £300,000 of which are due in 2022. They also had expenses of £500,000 and expect to pay £100,000 in 2022.
Under the cash basis accounting, Company DEF cannot recognise the sale of £300,000 and the expense of £100,000 as revenue and cost, respectively, since they will remain uncollected and unpaid as of the end of 2021.
On the other hand, Company ABC had sales of £1,000,000 and expenses of £500,000 for the calendar year 2021. In this case, for the year 2021, they had a profit of £500,000. Under accrual accounting, Company ABC’s revenues and expenses were all recognised in 2021 as they happened, regardless of the date of payment of the transaction.
Under the matching principle, the accrual method gives a better picture of the company’s financial status and performance. Revenues are matched with expenses as they occurred.
Under the cash basis accounting, we would not recognise these revenues and expenses until payment. If a sale were made in 2021 but still unpaid until 2022 or 2023, the management would misinterpret how much was sold in 2021 since there was no collection on other sales made in 2021.
For most medium to large corporations, accrual accounting is the better method because it fairly reflects the company’s financial performance over a specific period better than the cash basis method.
Examples of cash vs accrual accounting
A landlord rents an office building for £500. Assume the tenant pays the month’s rent during the first day of the following month. For example, the rent for December 2021 is yet to be paid come 1st January 2022.
Under the cash basis, the recognition of the income from rent will not happen until the payment of rent on the first day of the following month.
Under the accrual basis, the landlord should, at month-end, make a journal entry on the month-end books to record a debit to rent receivable of £500 and a credit to rent income of £500. This entry will recognise the revenue even though the rent is yet to be paid on the following month.
A company made a payment for £12,000 in January 2021 for one-year insurance coverage.
Under the cash basis, you would record the £12,000 as an outright expense for January because you have paid for the insurance during that month.
Under the accrual method, you would have to accrue that amount for over twelve months, which means you recognise a £1,000 expense for every month over the next twelve months.
By mid-year or June, you would only have recorded £6,000 an as insurance expense.
Advantages & disadvantages of cash vs accrual accounting
When trying to figure out their financial performance or how the business performed during a specific period, some choose to look into their bank accounts. If a company has, let’s say, £1,000,000 in cash on their bank account as at the end of the accounting period, they would say that they performed very well during the year.
In reality, that is not the case. Money in your bank account does not equal your profit.
While it might work for tiny businesses, looking into actual cash on hand is unreliable for its financial performance.
Timing of transactions
If I have £1,000,000 cash in the bank at the end of the financial period, how much does that reflect my sales and expenses correctly?
Using the cash method, businesses are not able to record the sales and purchases as they happen. It only relies on the coming in and out of money. I might have a million in my bank account, but little do I know that I still have £600,000 in outstanding debts and only £100,000 in collectables, which makes my estimated profit of £500,000 and not £1,000,000.
The disadvantage of cash basis as an accounting method, whether for small or large businesses, is that it does not accurately represent a business’s financial position and performance at any point in time.
Why? If we base our recording methods on collecting a sale, we do not assume that a customer will pay the bill. What if the customer becomes delinquent and they don’t pay the bill until three years later?
When using the cash basis, there is no matching of revenues and expenses which eventually leads to inaccurate data presented to the management and may lead to poor management decisions.
The accrual method of accounting accounts for expenses when they happen. Therefore, a business can reliably produce data on how much was sold and expensed during a tax year regardless of when they were paid.
Management decision making
Using a cash basis is an advantage for very small businesses. Small businesses do not have many accrued expenses or revenues to account for, so cash performance is a more reliable method of accounting for profits and decision-making by the owner.
This, however, is a disadvantage for medium to large businesses that operate on numerous sales and expense transactions. Accrual accounting will be more advantageous for these corporations as the business’ cash balance won’t be a reliable method of accounting for performance anymore. Using the accrual basis will give the owners or the management a better overview of the business’ performance.
How to know which one to choose
According to the UK Government mandate, you are allowed to use the cash basis method if the following conditions are met:
- If you run a self-employed business, like a sole trader or partnership
- Have a turnover of £150,000 or less in a year
Even if you have more than one business, you must use cash-basis in all your businesses, but your combined turnover must not exceed £150,000.
Cash basis is easier to work with, especially for small businesses and sole traders with little to no time and budget for rigorous administrative work brought about by applying traditional accounting (also called accrual basis).
What if I exceed the £150,000 threshold during the year?
You can continue applying the cash basis method for up to £300,000 per year if you claim universal credit (UC). You will be required to use the traditional accrual accounting method beyond that for your next tax return.
At the same time, limited companies and limited liability partnerships are not allowed to employ cash basis accounting, leaving them no choice but to apply the accrual method in their recording process.
Other specific business types who are not allowed to use the cash basis as per the UK government are as follows:
- Farming businesses with a current herd basis election
- Farming and creative businesses with section 221 ITTOIA profit averaging election
- Businesses that have claimed business premises renovation allowance
- Businesses doing mineral extraction trade
- Businesses that have claimed research and development allowance
- Dealers in securities
- Relief for mineral royalties
- Lease premiums
- Ministers of religion
- Pool betting duty
- Intermediaries are treated as making employment payments.
- Managed service companies
- Waste disposal
- Cemeteries and crematoria
Cash basis is designed to help small, unincorporated businesses like sole traders and partnerships simplify their accounting processes and file Self Assessment tax returns. We recommend the cash basis accounting method for sole traders under these circumstances.
Remember that this is not an automatic option if you have decided to apply the cash basis as a sole trader. You must indicate it so on the Self Assessment tax return.
However, keep in mind these things why cash basis might not be suitable for you even if you are eligible to employ cash basis, according to the UK Government website:
- Want to claim interest of bank charges of more than £500 as an expense. Bank, loan and interest costs are allowed up to £500 under the cash basis.
- Have more complex businesses
- Plan to apply for bank financing. Most banks may need to see financial records done using traditional accounting to get an idea of your debts and receivables before the loan is approved.
- With losses, you want to offset against other income, also known as sideways loss relief.
While cash basis makes the accounting process more straightforward for many small UK businesses, you would still need to keep proper business records for your Self Assessment Tax Returns and as a requirement for the HM Revenue and Customs.
You would still need to keep your sales and income records, business expenses, VAT records (if VAT registered or required), PAYE records (if you have employees), personal income records, and grants.
If using the traditional or accrual accounting method, you would also need the documents mentioned above and records of all your collectables, payables, value of stocks and work in progress. You must also maintain year-end bank and cash balances, a history of investments, and all withdrawals made from the business.
Keep these accounting records for at least five years after the January 31 date of submission on the tax year.
Bank and interest costs
Suppose you anticipate that bank, loan and interest costs will be more than £500 in a taxable year. In that case, you might want to adopt the traditional basis instead of the cash basis and get tax relief on business-related financing expenses.
When taking stock for personal use, the cash basis method values stocks at cost price. In the traditional accrual method, stocks are accounted for at market value at the time of withdrawal.
Buying capital equipment
Under the cash basis, the treatment of capital equipment is an outright expense except for land, buildings and cars. This treatment gives way to more straightforward computation since you do not need to compute for capital allowances of eligible capital expenditures.
On a cash basis, you can only offset trade losses against future business profits. With this reduced opportunity for loss relief, carried forward of losses against gains of the same business.
Meanwhile, under the traditional method, you can offset losses even from three years prior or from other income in the same year.
So, what exactly is the best method to use?
If you expect fast business growth, you might want to use accrual rather than a cash basis from the getgo. Also, suppose you are wary of the particular points as indicated above (bank and interest costs, complex business structure, loss relief, capital equipment, and financing). In that case, you might want to switch or choose accrual accounting rather than a cash basis.
Meanwhile, despite the wide use of accrual accounting, it can have its pros and cons too.
Pros and Cons of Accrual and Cash Methods
Accrual accounting reflects your company’s financial performance more accurately than cash, but it also requires a more detailed preparation of a cash flow statement. Many companies who adopt an accrual basis might find relief in knowing how much profit they’ve had over a certain period. Only to see through their cash flow statement that they don’t have enough cash due to high volumes of outstanding receivables.
From a tax perspective, this also means that a company adopting the accrual method will have to pay the corresponding tax for the revenues reported for the year even though they are yet to be paid. Adopting the cash basis method, the company only has to pay for the tax of the revenues collected since we only report income based on the actual cash received.
Under the cash basis, however, businesses are prone to overestimating their performance upon seeing a huge cash balance, even with an underlying amount of unpaid debts as of year-end.
Both methods have their advantages and disadvantages. It is crucial for business owners to assess based on their understanding of their business and its growth and assess which way is best under the circumstances.
Changing from cash to accrual accounting
HMRC will assume you adopt the accrual method if you don’t indicate you are using the cash basis on your Self Assessment tax return.
Changing from cash to accrual accounting is common, especially for those businesses that exceed the £150,000 or £300,000 threshold or those who choose to elect the accrual method for their convenience.
It is best to adopt accounting software that would guide you through the proper recording process of accruals. We recommend shifting from the cash to the accrual method at the end of the tax year to ease the transition.