Should small businesses use cash or accrual accounting?

As a business owner, you may be passionate about your trade and company but may not share the same passion for accounting and bookkeeping. However, keeping an accurate account of your finances is vital to help you stay afloat and grow your business. 

There are two types of accounting you can use: cash and accrual accounting. But which method is best for you?

This guide will help you choose which accounting method to choose for your business by looking at:

• What cash and accrual accounting is respectively, including benefits and drawbacks
• The difference between the two methods
• Which method small businesses should use
• How Countingup helps small businesses with their accounting

Cash accounting only recognises revenue (money earned from sales) and expenses once money changes hands. This means that you only record these transactions when you receive or pay the money.

This method is only applicable to very small businesses that run on a self-employed basis. The cash accounting basis is the simplest and most straightforward method available. It gives small businesses a clear picture of how much money they have on hand.

• It’s simple and shows how much money you have available at a given time.
• It can save you having to pay for an accountant since you can manage it yourself.
• It’s an easier option for calculating tax, though not all businesses are allowed to use it. Check the HMRC website for specifics.

• It’s not accurate since it only records payments that have already been made. For example, it could show you as profitable only because you haven’t paid your bills yet.
• You might struggle to secure financial backing if you use cash accounting. This is because banks and other lending institutions need a more holistic view of your finances to extend a loan.

Accrual accounting is also referred to as traditional accounting. This method involves recording expenses and income when they’re billed or earned instead of when the money actually changes hands.

For example, if you made £2,000 in sales one month, you’ll record that £2,00 that month, even if you don’t receive all the money until the next month.

It works the same way for expenses, meaning if you buy supplies on credit one month, you record the expense that month even if you don’t have to pay until the next month.

• It’s approved by the UK General Accepted Accounting Practices (UK GAAP).
• You get a much more accurate picture of how your business is performing financially.
• Having a complete view of your finances means you can make decisions with more confidence.
• As we mentioned earlier, banks and other lenders need a holistic view of your financial health to give you financial backing. Accrual accounting can sometimes make it easier to pitch for long-term finance.

• It’s more work since you have to keep track of credit and debit payments, including invoices, bills, debts, and revenue.
• You may have to pay tax on income before the customer has actually paid you. If the customer reneges on the invoice, you can claim the tax back on your next return.
• While the accrual basis of accounting provides a better long-term view of your finances, the cash method gives you a better picture of the funds in your bank account. 

Accrual accounting records revenue and expenses as they occur without waiting for the money to exchange hands. You calculate your company’s assets (valuable items owned by the business), liabilities (expenses and debts) and equity (company worth) at the time invoices are sent and received.

This form of accounting allows you to combine your current cash flow (movement of money through your business) with your expected future cash flow to give you a more accurate picture of your business’s current financial position. 

Cash basis accounting only shows you the money you have available now.

Only businesses that make under £150,000 per year (annual turnover) can use this cash accounting. There’s an exit threshold of £300,000 annual turnover, so if you pass the £150,000 limit, you can continue using cash accounting until the end of that tax year. After that, you must switch to accrual accounting.

Additionally, cash accounting might be the perfect solution when your company is small and has limited expenses and income. Once you start bringing in more money, expand your product range, or add more services, you may find that cash accounting is no longer enough.

Accrual accounting also helps you determine if you’ve done better one month compared to another one since you record financial activities when they happen. 

Some businesses choose to combine cash and accrual accounting (called hybrid accounting). If you opt for this method, you might use accrual accounting for loan applications but use cash accounting to simplify some elements of your tax.

While accrual accounting does require more work, technology can help do most of the legwork for you. If you set up accounting software like Countingup, features like automated invoices, receipt capturing, tax estimates, and cash flow reports help make your accounting easier. 

Countingup is a business current account that comes with free built-in accounting software that automates the time-consuming aspects of bookkeeping and taxes. Instant invoicing, automatic expense categorisation and cash flow insights mean that you can confidently keep on top of your business finances every day.

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. It is seamless, simple and straightforward!

Download the Countingup app to apply for your business current account in minutes. All you need is proof of ID and a recent photograph. Download the app here.