If you run a business or you’re just starting up, then you’ll need to decide whether to use traditional or cash accounting. Don’t panic, we’ll talk you through it.
Bookkeeping records consist of income and expense accounts which show how much money comes into an organisation, and how much goes out. The way that you record transactions in these accounts depends on whether you use cash basis or traditional accounting.
In this post we’ll give you an overview of what traditional and cash basis accounting mean, along with some pointers to help you choose.
- What is cash basis accounting?
- What is the traditional accounting method?
- What are accruals?
- Choosing the best accounting scheme for your business
What is cash basis accounting?
Under the cash basis method, revenue (income) and expenses are recognised at the point that you actually receive or pay the money. For example, if you send an invoice today and your customer pays in 30 days’ time, then you would recognise the income at that point and not when you send the invoice out.
If you order something from a supplier, the purchase is recognised at the point that you make payment, rather than when you receive the order or the date on the invoice.
Can my business use cash basis accounting?
Cash basis accounting isn’t for everyone, and there are restrictions as to who can use this method. You can use cash basis accounting if:
- You operate as a sole trader or a partnership. Limited companies are not allowed to use cash basis accounting.
- The turnover for your business is £150,000 or less per year when you start using this method. If you join the scheme and your business grows, you can continue using cash basis accounting until your total turnover reaches £300,000.
Can I use different accounting schemes for different businesses?
If you have more than one sole trader or partnership business, you’ll need to use the same accounting scheme for each of them. This is because sole traders and partners aren’t legally separate from their business in the way that the owner of a limited company is.
You can only start using cash basis accounting for your businesses if the total turnover from all of them is less than £150,000.
What is the traditional accounting method?
Traditional accounting is where transactions are recorded in your bookkeeping using the date on the invoice or bill.
When you invoice a customer, it’s recorded as income on that day, regardless of whether the customer has paid you or not.
The same goes for costs. When you incur costs, they’re recorded using the date on the invoice whether or not you’ve paid. There’s a twist here though because we also need to think something called accruals.
What are accruals?
Imagine that you run a power-intensive business using lots of electricity, but you haven’t received a bill yet.
This could be for a substantial amount of money, but under the cash basis you wouldn’t record it in your accounts until you actually pay the bill. As a result, your profit and loss and balance sheet could actually be wrong by a sizeable amount.
- Your profit and loss (P&L) won’t show a true profit picture, because there are still some costs that you need to record
- The balance sheet won’t be accurate because it doesn’t show the full extent of how much money the business owes.
So, the accrual method is a way of putting some money aside to pay a bill that we know is due.
An example of accruals in the wild
Let’s say it’s January, and we know that we are using £1,000 worth of electricity a month. We know that our P&L is light by £1,000, and we know that our balance sheet is showing £1,000 too little in the way of liabilities, because we know we owe the electricity company this amount.
An accrual works like this; each month you make an entry for the amount of money you know you have spent, and you put the other side of the entry onto the balance sheet under liabilities (accruals).
You do this until you get a bill, and then you unwind the transactions. Here are the monthly journals to illustrate.
|Electricity (P&L Account)||£1,000||This is the P&L entry increasing our costs|
|Accruals (Balance sheet)||£1,000||This is where we are ‘storing’ our money|
|Electricity (P&L Account)||£1,000|
|Accruals (Balance sheet)||£1,000||Our running total in accruals is now £2,000|
|Electricity (P&L Account)||£1,000|
|Accruals (Balance sheet)||£1,000||Our running total in accruals is now £3,000|
|A £3,00 bill arrives and we pay it||Debit||Credit||Details|
|Accurals||£3,000||So now the running total is zero|
Now in the same way as you can accrue for expenses, you can also accrue for sales. Typically, this will be where you have already supplied goods or services, but not yet sent out the invoice.
The accrual method means that your Balance Sheet and P&L will show more of a ‘true and fair’ view of how your business has done. This is important because you don’t want to think you are having a great month, only to find out later that you have a whacking great electricity bill to pay!
What are the downsides of using the accrual method?
The accrual method is beloved by accountants because it tends to paint a more realistic picture, so why doesn’t everybody use it? Well in truth, the majority of larger businesses do use the accrual method but there are some downsides.
As we saw above with a very simple example, it takes a while to get your head around things. If you have a lot of accruals of both income and expenses, then it can take a lot of administering. This means that you may need to employ someone who has more specialised accounting knowledge.
It is also true to say that there tends to be a gap between how the P&L looks and what is in the bank account. That means that you may need to produce a separate cash flow forecast, and you may want a reconciliation between the profit you have made and the money that has actually hit the account.
Keeping track of what customers owe you is also a key aspect to keep on top of, so good bookkeeping (as always) is a must!
Cash basis versus traditional accounting: which one is right for my business?
There isn’t really a straightforward answer to this because it depends on the business itself. For example, a smaller business or start up might find it easier to record transactions using cash basis accounting, because then you’ll only need to pay tax on the money that you actually receive. So, if you run a business in an industry where customers tend to pay their invoices a bit later, you won’t pay tax on that income until they actually pay you.
On the other hand, a small business which buys stock in the morning and then sells it during the day won’t really have much to gain from this method!
The cash method might also be inappropriate for your business if you’re planning to apply for finance. This is because any lender will want to see a fair representation of your accounts before agreeing to anything.
It’s always a good idea to chat with an accountant to go through things in more detail. They can also help you set up bookkeeping systems, and train you (and any staff) in using them.
Using accounting software
Good accounting software (like Pandle!) will make it much easier to create and maintain good bookkeeping records whichever accounting system you choose. Look for providers who include robust features to automate more of your admin, and help to reduce the risk of errors.