Being able to stay on top of your finances accurately is one of the best skills that you can have under your belt as a small business owner.
And thanks to a wealth of accounting software that runs the numbers for you and keeps your documents safe, it’s now easier than ever to keep your books in order.
However, before you get started with the best accounting software for your business, you need to decide between two different methods of accounting: accrual accounting or cash accounting.
In this guide, we’ll walk you through both methods, the pros and cons of each and whether your business would be better with accrual vs cash accounting.
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Accrual vs cash accounting: what’s the difference?
Let’s start with a quick overview of the different types of accounting that accrual vs cash accounting offers.
Both accrual and cash accounting are methods of recording your revenue and expenses, with just one key difference. This is the point at which you recognise them within your finances.
- For cash accounting, you only record revenue or expenses as they’re paid. So when the money leaves or enters your account, it gets recorded.
- Accrual accounting records anticipated expenses and revenue. These expenses are recorded when an invoice or bill is sent or received rather than when the money leaves your account.
Some small businesses prefer cash accounting as it’s easier to keep track of. However, some businesses may prefer accrual accounting to keep track of finances that haven’t come in yet to get a more accurate view of the business. For larger businesses, accrual accounting will be required.
|Cash accounting||Accrual accounting|
|Transactions are recorded when cash is received or money is spent.||Transactions are recorded when a sale occurs or an expense is incurred.|
|Tax liability incurred when the income is received.||Tax liability incurred when the income is recorded.|
|Simple and straightforward for people to use.||More complex and unintuitive for established businesses.|
|Not required for businesses of a certain size.||Required for businesses of a certain size, or those that carry inventory or sell goods on credit.|
There are pros and cons to both of these approaches, which we’ll explore in more detail in the next section.
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Cash-based accounting, the pros and cons
As we outlined before, cash-based accounting is about recording your outgoing and incoming expenses as they enter and leave your account. Basically, this type of accounting only records your activity when you pay (or get paid).
It’s also worth noting that although this method of accounting is named cash-based accounting, it doesn’t necessarily have to use cash. Bank transfers and online payments are allowed – it’s just the way that you record your expenses.
Some benefits of cash-based accounting are:
- You can see the cash you have on hand. This will give you an accurate view of what your bank accounts are like at that very moment without having to think about expenses going out or income due.
- You get more control over your transactions, which can help with better cash management or even some tax benefits.
- It’s easier to calculate and pay your tax. With cash-based accounting, you pay tax on the income that’s actually in your account rather than what is due to arrive. That means you’ve always got the income ready to pay your tax bill on time.
On the reverse, some disadvantages of cash-based accounting are:
- It’s less accurate. Your business could be showing a healthy profit – just because you’ve received income and haven’t paid your bills yet.
- It can be harder to plan with real-time views, especially if you need to account for several upcoming expenses or invoices, which are hard to see in this way of accounting.
- It doesn’t show your liabilities because your future payables are missing from this account.
- It’s harder to transition from accrual-based accounting. So if you want to start cash based but switch to accrual as you go, you may end up with files being mismanaged as you try to swap which method of accounting you use.
At Business4Beginners, we recommend cash-based accounting for small companies that don’t plan on stocking inventory or selling goods on credit, as it will be hard for you to transition to accrual accounting later on.
Accrual-based accounting, the pros and cons
In accrual-based accounting, you record revenue and expenses when the sale or expense occurs, not when the money enters or leaves your account. This gives you a more accurate view of your accounts and what money is due to enter and leave, not just your current view of your bank account.
The benefits of using accrual-based accounting are:
- You can see future revenue and expenses, giving you a much more accurate view of your accounts.
- You can plan your finances better, as you’ll have a full picture of all payables and receivables rather than make decisions based on what’s in your account right now.
- You’ll find it easier to pitch for long-term finance, as you can show a more accurate picture of your finances to potential investors.
- You can access tax savings through the depreciation of certain assets.
As always, there are some downsides to this method. For accrual-based accounting, the negatives are:
- It requires more work as you’ll have to enter all your expenses and invoices as they are received rather than just track your bank activity.
- There are more rules to follow about what type of transactions you need to record.
- It doesn’t show the money you have available right now, as you’ll see the balance after pending transactions. You’ll have to go into your bank account to get this information.
- You might have to pay taxes on income that hasn’t arrived yet, depending on the timing of the sale. This might mean you’ll have to keep extra aside to cover your taxes.
If you’re a small company, the choice between cash and accrual accounting is down to your personal preferences. However, if you:
- Have a turnover of over £150,000;
- Manage an inventory;
- Sell items using credit.
Then using accrual-based accounting is mandatory.
Accrual vs cash accounting: an example
To give you a better view of how accrual and cash accounting will affect your finances, let’s work through this example together using both accounting methods.
For this example, we have Joan’s teapot company, which makes unique clay-fired teapots. In one month, Joan will:
- Buy supplies for £1500;
- Pay £500 in utilities;
- Be billed £300 for repairs to her kiln;
- Make £4000 in sales;
- Send a £2000 invoice for a custom order for a hotel chain.
Using the cash-based accounting method first, we only record the transactions that have already occurred. So, ignoring the bill for kiln repairs and the invoice, Joan has outgoings of £2000, and an income of £4000. Overall, this leaves her with a positive balance of £2000.
Using accrual-based marketing, we record all transactions as they are billed and invoiced. This brings her total outgoings to £2300, and total income to £6000 – leaving her with a positive balance of £3,700.
Cash vs accrual accounting: which is right for my business?
Now we’ve run through the pros and cons of both cash and accrual-based accounting, it’s time to decide which one is right for your business.
This is down to your personal preferences unless your turnover is higher than £150,000 a year, manage inventory or sell items on credit. If your business falls under those categories, then you will need to use accrual-based accounting.
If you’re not hitting those criteria just yet – but are planning to in the long term, then you might want to consider starting with accrual-based accounting to set you up for the future. This is because it’s hard to transition from cash to accrual-based accounting.
If you’re looking for the easiest way to do your accounting, then cash-based accounting might be the right call for you. This is because it needs less paperwork and attention as you’ll only record transactions as they happen in your bank. Plus, with the help of accounting software, most platforms will be able to integrate with your business bank account and automatically pull this information across for you.
To find out more about how accounting software can make keeping on top of your financials easier, whether you use cash or accrual-based accounting, take a look at our top-rated UK software here.
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Can you use both cash and accrual accounting?
Technically, yes, you can use a hybrid approach to your accounting.
A hybrid approach is where you use cash-based accounting for your everyday financials and keep on top of your expenses. However, when it comes to big planning decisions or applying for investment, you might choose to prepare your accounts using the accrual-based accounting method to get a more accurate and realistic view.
To do this hybrid method, we’d recommend setting up your accounting software in the cash-based accounting method. Then, when you need to prepare your accounts in the accrual-based method, you might want to enlist the help of an accountant to help get your accounts in order.
Cash vs accrual accounting explained
Cash and accrual accounting are two methods that you can choose to record and keep on top of your financials. Both are very similar, with a key difference: the timing of when you record your incoming and outgoing transactions.
Cash-based accounting will record transactions as they physically happen in your account. Alternatively, accrual-based accounting will record transactions once invoices or bills are sent and received.
Both methods have their pros and cons. But with this guide (and the advice of your accountant!), you can choose the right method for your unique situation. And, no matter which one is right for your business, you can use accounting software to make the whole process easier and less time-consuming.