Cash Accounting v Accrual Accounting

When running a business, it is important to understand when income and costs should be recorded. The two main methods are cash accounting and accrual accounting. Both can be correct, but the best choice depends on the business structure, complexity and what the figures are needed for.

What Is Cash Accounting?

Cash accounting records income when a customer pays and expenses when the business pays a bill. For example, if you invoice a customer in March but receive payment in April, the income is recorded in April.

Cash basis is the standard method for many sole traders and partnerships without corporate partners. It is simple, follows the bank account and can help cash flow because tax is not normally due on income that has not been received.

However, it may not show unpaid customer invoices or supplier bills, so it can give an incomplete picture of performance.

What Is Accrual Accounting?

Accrual accounting records income when it is earned and costs when they are incurred, regardless of when payment is made. In the same example, the sale would be recorded in March, when the invoice was raised.

Limited companies normally use accrual accounting. It provides a fuller view of profit, debtors, creditors, stock and other commitments. This makes it particularly useful for management accounts, business planning and finance applications.

The disadvantage is that it requires more detailed bookkeeping and year-end adjustments. A business may also pay tax on income before the customer has settled the invoice.

What About VAT?

VAT accounting is a separate decision from the method used for the business accounts.

Under standard VAT accounting, VAT is generally reported using invoice dates. A business might therefore pay VAT to HMRC before its customer has paid.

Under the VAT Cash Accounting Scheme, sales VAT is paid when customers pay and purchase VAT is reclaimed when suppliers are paid. This can help businesses with slow-paying customers, although it may delay VAT reclaims on unpaid purchases.

A business can normally join the scheme where its estimated VAT-taxable turnover is no more than £1.35 million.

Which Method Is Best?

Cash accounting often suits straightforward businesses with little stock. Accrual accounting normally suits limited companies and businesses needing a clearer view of their financial position.

Good bookkeeping is important whichever method is used. The right choice depends on business structure, cash flow, VAT position and reporting needs.