When running a business, it’s crucial to understand how to track your finances. Two common methods are cash accounting and accrual accounting. Here’s a simple breakdown of what they are and when each might be used.
Cash Accounting:
- How It Works: With cash accounting, you only record income and expenses when money actually changes hands. For example, if you send an invoice on 1st September but don’t get paid until 15th October, you’d record the income in October, when the money hits your account.
- When to Use It: This method is typically used by small businesses and sole traders with a turnover of £150,000 or less (this is the threshold for using the Cash Basis for tax purposes). It’s simpler because you don’t need to track accounts receivable or payable – you only record transactions when money moves.
- Example: A freelance graphic designer who issues invoices and often waits for clients to pay would benefit from cash accounting. They only pay tax on the money they’ve actually received, which helps with cash flow management.
Accrual Accounting:
- How It Works: Accrual accounting records income and expenses when they’re earned or incurred, regardless of when the money is actually received or paid. For example, if you send an invoice on 1st September, you record it as income in September, even if you don’t get paid until October.
- When to Use It: This method is often required for larger businesses or those with a turnover above £150,000. It gives a more accurate picture of a company’s financial health because it includes all owed expenses and income, not just what’s been paid.
- Example: A retail business that orders stock and sells on credit might use accrual accounting. They need to track what they owe to suppliers and what customers owe them to understand their financial position fully, even if the cash hasn’t yet moved.
Which One Is Right for You?
- Cash Accounting: Best for smaller businesses or sole traders who want to keep things simple and have straightforward transactions.
- Accrual Accounting: Suited for larger or more complex businesses that need a detailed view of their finances.
What About Limited Companies?
Limited companies must use accrual accounting. This is because limited companies are required to provide a true and fair view of their financial position, which accrual accounting achieves by recording all income and expenses when they are earned or incurred, not just when cash is received or paid. This method gives a more accurate picture of the company’s profitability and financial health.
Understanding these methods can help you choose the right one for your business, ensuring accurate financial reporting and effective tax management.