What is the cash accounting basis?

As a business owner, accounting might not be your favourite task. However, bookkeeping and accounting are crucial to the effective running of a company. Cash accounting aims to simplify the process as much as possible.

This guide will explain cash accounting by addressing the following:

●        What the cash basis of accounting is, and how it works

●        How it differs from accrual accounting

●        What the benefits and drawbacks are

●        When using cash basis accounting is a good idea, and when it’s not

●        How Countingup can help with your accounting

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

Cash accounting is an alternative to traditional accounting and 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 and gives small businesses a clear picture of how much money they have on hand.

However, only businesses that make under £150,000 per year (annual turnover) can use this method. There’s also an exit threshold of £300,000 annual turnover, meaning that after passing the £150,000 limit, you can continue using cash basis until the end of that tax year. Then you must switch to traditional accounting.

Traditional accounting (also known as accrual accounting) is a method that records revenue and expenses as they occur without waiting for the money to exchange hands. This form of accounting calculates a 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.

Accrual 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.

Let’s look at the pros and cons of using cash accounting:

The main benefit of the cash basis is how simple and straightforward it is to use. Because of its simplicity, you don’t need a lot of accounting experience to use this method.

Additionally, cash accounting could save you from having to pay for an accountant as you’ll likely be able to handle the finances yourself.

Sole traders and small businesses that carry no inventory and don’t get paid on credit often find cash accounting to be the best option. Cash accounting gives these small businesses all the information they need to determine if they are making enough money to cover their expenses.

One issue with cash accounting is that it can paint an inaccurate picture of a company’s financial health. This is because you can only record transactions as they happen.

Let’s look at an example. Say your business experiences a decline in sales one month, but a large number of clients from last month pay you at the same time. In that case, cash-basis accounting can be misleading since it only shows the influx of cash from the paid invoices – even though you actually made the sales last month. Cash accounting doesn’t show that sales are slow this month, meaning the information is misleading.

Additionally, banks and other financial institutions need a more holistic view of your financial position before lending you money. As a result, you might struggle to secure financial backing if you use cash accounting.

Cash accounting is useful if you get paid immediately when you complete a task and only buy items when you can afford them. Additionally, if you run a business where you don’t use invoices, such as running a small clothes shop, cash accounting might be a good option.

Other situations where businesses might use cash accounting also include:

●        When they use simple single-entry bookkeeping, which also only records transactions as they happen.

●        When they operate as a sole trader and don’t need to publish financial statements.

●        If the business does not deliver goods and services on credit (meaning you give customers a set amount of time to pay their invoice).

●        If the business only has a few financial transactions each day.

●        When the company has no inventory to be tracked or valued, like service businesses.

While cash accounting might do you find at the beginning of your business venture, you might need to reconsider your methods as you grow.

Here are a few situations when cash basis accounting would not suit a business:

●        If you want to claim interest or bank charges of more than £500 as an expense.

●        If you run a more complex business, with high levels of stock and a lot of client credit accounts to track.

●        If you need to secure funding for your business. A bank might ask to see accounts that require traditional accounting to see what you owe and are due before agreeing to give you a loan.

If you’re unsure if cash basis accounting is for you, you could reach out to an accountant for advice.

Additionally, investing in modern accounting software will simplify your accounting significantly by automating many complex and time-consuming bookkeeping tasks.

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.