What Is Cash Accounting?
Cash accounting, on the other hand, is a simpler accounting method where transactions are only recorded when cash is received or paid. In this system, you only record income when the payment is received and expenses when they are actually paid.
Key Characteristics of Cash Accounting:
- Revenue Recognition: Revenue is only recognised when you receive payment from a customer. For example, if you send an invoice in January but receive payment in February, the income is recorded in February when the payment is received.
- Expense Recognition: Expenses are recorded when they are paid, rather than when they are incurred. For example, if you receive a bill in December but pay it in January, the expense is recorded in January.
- Simplicity: Cash accounting is much simpler to manage because it doesn’t require tracking accounts receivable (money owed) or accounts payable (money owed to suppliers). It’s more straightforward for businesses with relatively few transactions.
- Cash Flow Focus: Cash accounting focuses on cash flow, making it ideal for businesses that need to manage their day-to-day cash position.
When Should a Company Use Cash Accounting?
Cash accounting is suitable for smaller companies or businesses with straightforward financial transactions. It’s commonly used by:
- Sole traders or small businesses with lower turnover.
- Businesses that don’t need to produce complex financial reports or follow IFRS/UK GAAP.
- Companies that mainly deal in cash transactions or have simple billing systems.
- Limited companies with a turnover of £1.35 million or less may be eligible to use the cash basis scheme, provided they meet other criteria.
Cash basis accounting is the default method of accounting for sole traders and partnerships for the 2024/25 tax year (which started on 6th April 2024) onwards.
Key Differences Between Cash and Accrual Basis of Accounting
Now that we’ve covered the basic definitions of both methods, let’s explore the key differences:
- Revenue and Expense Recognition Timing
- Accrual Accounting: Recognises revenue and expenses when they are earned or incurred, regardless of when cash is received or paid.
- Cash Accounting: Recognises revenue and expenses when cash changes hands (i.e., when payment is received or made).
- Complexity
- Accrual Accounting: More complex and requires keeping track of accounts receivable and payable, making it suitable for larger or more complex businesses.
- Cash Accounting: Simple and easy to maintain, making it ideal for small businesses with fewer transactions.
- Tax Implications
- Accrual Accounting: Since income and expenses are recognised as they occur, your taxable profits may be higher, even if you haven’t received all the payments or made all the payments yet. This could lead to paying taxes on income you haven’t yet received.
- Cash Accounting: With cash accounting, taxes are only paid on income you’ve actually received, and expenses are deducted only when they are paid. This method may help with cash flow management, especially for businesses with irregular income.
- Financial Reporting
- Accrual Accounting: Provides a clearer and more accurate view of a company’s financial health over time, since it matches income with the expenses incurred to generate that income. This method is essential for producing balance sheets and income statements.
- Cash Accounting: Offers a simplified view of your business finances, focusing on cash flow rather than overall profitability. This method may not give a complete picture of your business’s financial position.
- Business Size and Growth
- Accrual Accounting: Typically used by larger businesses or those with more complex financial structures, such as businesses that are growing quickly, applying for loans, or seeking investors.
- Cash Accounting: Ideal for small businesses, sole traders, or new businesses that do not have complex financial reporting needs.
Which Accounting Method is Right for Your Company?
The choice between accrual and cash accounting depends on the nature of your business and your financial goals. Here are some factors to consider when choosing between these two accounting methods:
- Size of the Business: Larger businesses with complex transactions or high turnover are better suited for accrual accounting. Smaller businesses with straightforward financial activities may find cash accounting simpler and more manageable.
- Cash Flow Management: If managing cash flow is crucial for your business, cash accounting may provide the clarity you need by focusing only on actual cash transactions.
- Tax Considerations: Accrual accounting may result in paying tax on income you haven’t yet received, while cash accounting only taxes income that has actually been paid. Consider the impact on your tax payments when choosing a method.
- Legal Requirements: Some businesses, particularly larger limited companies, may be required to use accrual accounting under UK GAAP or IFRS standards. If you are seeking external investment or planning to go public, accrual accounting may be necessary.
Conclusion: The difference between cash and accrual basis of accounting
Choosing the right accounting method is an important decision that affects your financial management and reporting. Accrual accounting provides a more accurate picture of your company’s financial position, making it ideal for larger businesses or those that need detailed reports for investors or lenders. On the other hand, cash accounting is simpler and may be more suitable for smaller businesses or those focused on cash flow.
Ultimately, the method you choose will depend on the size and complexity of your business, your reporting needs, and your financial goals. If you’re unsure which method is best for your limited company, consulting with an accountant can help ensure you make the right choice for your business’s future.
