Cash and Accrual Accounting Explained
Getting your accounts in order can be a minefield. Here is what you need to know when deciding whether to use cash or accrual accounting.
Think about when you record revenue or expenses. Is it when you pay or receive money? This is cash accounting. If you do it when you receive or raise an invoice, then you are using accrual accounting.
This method recognises revenue when cash is received, and you have paid any expenses. You can use this scheme if you are:
· A sole trader or partnership running a small self-employed business
· Making less than £150,000 turnover per year
Limited Companies and Limited Liability Partnerships cannot use cash accounting. Others who are not eligible can be found here
Advantages of Cash Accounting
· It’s a simple process
· It shows you how much money your business has at any given time
· When calculating tax, it’s an easier option.
Disadvantages of Cash Accounting
· It isn’t always accurate. It may show you as profitable because you haven’t paid some bills.
· It only gives you a day-to-day view of your finances. This isn’t particularly helpful when you are making management decisions.
This method is used when revenue and expenses are recorded at the point they are earned, regardless of whether the money has been paid or spent. It is a more commonly used method than cash accounting.
Benefits of Accrual Accounting
· It gives you a much more accurate picture of your finances
· You can make financial decisions with confidence knowing your financial records are accurate
Disadvantages of Accrual Accounting
· It involves more work because you have to watch your invoices as well as your bank account.
· You may have to pay tax upfront before a customer has made their payment.
What if I am VAT registered?
Cash accounting and accrual accounting are the two most popular VAT accounting methods.
Generally, you calculate VAT on the basis that the VAT you pay to suppliers is deducted from the VAT you collect from clients. If you are paying more VAT than you are receiving, you can reclaim this from HMRC.
Which method should I use?
In the main, cash accounting for VAT is kinder to small businesses. This is because you only pay VAT to HMRC once your customers have paid you. This makes it easier on your cash flow and is simple to calculate.
You need to be aware that this method is only available if your VATable sales are under 1.35 million per year, you haven’t been convicted of a VAT offence in the last twelve months, and your VAT returns and payments are up-to-date.
Accrual accounting for VAT doesn’t take into account when payments were made or received. You are required to calculate your VAT based on when an invoice was received or issued.
Because this method requires a business to have sufficient cash reserves, it tends to be adopted by larger businesses with a high turnover. It is the mandatory method if your taxable turnover exceeds 1.35 million per year.
If you want advice on which method you should be using for your business, please get in touch. I may also be able to help set you up with accounting software that will take away the headache all this can cause. It doesn’t have to be complicated.