Tax accounting V cash accounting – Which is best for you?
How do you decide between cash basis accounting and accrual accounting, AKA tax accounting? You need to make the decision before you begin recording business transactions for HMRC, and the biggest difference concerns the way you record cash transactions.
Here's a common sense look at the difference between tax accounting and cash accounting, and what they might mean to your business.
About cash accounting
Cash accounting involves recording every single transaction you make at the point the money actually changes hands, either when you get a cash payment from a customer or make a payment to someone else for goods or services. 'Cash' doesn't just mean the folding stuff. It also covers cheques, credit cards, electronic bank transfers and any other way of paying.
You can't use cash-basis accounting when you provide credit for buyers and they pay later. The cash accounting method doesn't allow you to either record or track money due from customers in the future. The same goes for purchases. If you buy goods or services on credit and will pay at a later date, you can't record the transaction until the money – in whatever form – has been handed over.
Cash based accounting works well for small businesses
Cash accounting tends to work well for smaller businesses, either those run by a sole trader or a low-key partnership with just a few partners, simply because it's so easy. But as businesses grow, the majority of business owners tend to switch to tax accounting to track their income and expenses more accurately.
While cash accounting does a great job of tracking actual cashflow, it's not much use for matching income earned with expenses. This can be a big issue, especially when a business buys products in one month and sells them the next.
Cash accounting example
Imagine you buy a stock of product for £1000 in June and sell the stock in July, which means you don't get the money until July. You complete your books for June, including a £1000 expense without any income to offset it. It means your books show a loss in that month, which isn't strictly accurate.
You sell the products in July and make £1500, which shows up as a £1500 profit. Your monthly report for June shows a £1000 loss, July shows a £1500 profit, and nothing makes sense. In reality you made £500 over the two months.
Instant recording with tax accounting
With accrual accounting, AKA tax accounting, you record every transaction as it happens, whether or not the money has changed hands. You might have made a sale on credit, recording the transaction immediately in your accounts received account. You might buy goods on credit, which you also record straight away in your accounts payable account.
Accrual accounting has issues of its own. It's excellent at matching income and expenses, but not so good at tracking cash. And when you record the transaction when it happens instead of when the actual cash comes in, your income statement can look a lot healthier than it actually is – something to be aware of.
Say you run a plumbing business. You can record income when you finish the job, having invoiced the customer, even if you don't have the money yet. If customers delay paying, you can easily end up with a whole load of revenue but no actual cash.
Tax accounting works perfectly when you need ready cash
You can use the tax accounting method to keep an eye on your cashflow, ensuring there's always enough to run the business week to week. If you run a seasonal business with highs and lows, you can harness short-term bank credit to keep the cash flowing when things are quiet.
Which suits my business best?
Every business is unique. The accounting method you choose depends on your particular circumstances. And it isn't set in stone. You might start out using one method and move to the other once the business has bedded in.
It's our job to make a sensible recommendation based on where you are now and where you want to be in the future. Feel free to contact us to find out more about our expert bookkeeping, VAT and Payroll services.
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