Cash accounting: 3 things to know
The rules which a company follows when recording and reporting its income and expenditure is known as the “accounting method”. There are two main accounting methods: cash accounting and accrual accounting.
Governments may require businesses of a certain size or in a certain sector to report their financial transactions according to a specific accounting method. It is essential to know which method your business may be required to use, and to understand how this impacts on your day-to-day bookkeeping. Find out more with Mooncard.
What is cash accounting?
Cash accounting is the method by which receipts (income) and expenses (outgoings) are recorded on the basis of the time cash actually exchanges hands. It means that receipts and expenses are recorded when the cash sum comes into and leaves the company. It is contrasted to “accrual” accounting, which records income and expenditure when the transaction takes place rather than when the relevant invoice is actually settled.
The advantages of cash-based accounting
Cash accounting is the simpler and more straightforward of the two accounting methods. It means the bookkeeper, accountant or business owner records transactions as and when money comes into and leaves their account and provides an accurate picture of how much cash the company has available.
It is a method that is, for most small businesses, easy to implement. Bank statements provide a straightforward record of when money enters and exits the company account. Often, a dedicated accountant is not required, as transactions can easily be recorded in house, using simple tools or accounting software.
Another advantage of cash accounting for many small businesses, is that VAT is only due to the government when the invoice is actually settled by the end client, not when the invoice is issued. Small businesses can often encounter cash-flow difficulties due to late payers, and the cash-based system means that they do not have to pay the VAT until the client has paid the bill.
Example of cash accounting
Let’s look at a simple example of cash accounting in practice.
A small business starts February with an opening balance of £10,200. On the 5th of the month, it pays a £250 electricity bill. On the 7th it purchases and completes the payment for £500 of stock. On the 10th it sells £600 of stock for cash. On the 15th it pays a £35 internet bill and £75 for mobile phone usage. On the 20th it makes another £250 in cash sales. On the 28th, it pays out £1,200 in wages.
Its cash accounting entry would look something like this:
|1 February||Opening balance||£10,200|
|5 February||Electricity bill||£250||£9,950|
|7 February||Stock purchase||£500||£9,450|
|15 February||Internet bill||£35||£10,015|
|15 February||Mobile phone bill||£75||£9,940|
|28 February||Closing balance||£8,990|
Obviously, this is an extremely simplified example and companies would have many more cash flows than those represented here. However, it does illustrate how easy the cash-based method is to apply in practice.
Where it becomes slightly more complicated is when credit is involved.
Imagine, for example, that during the month, the company also buys a new printer for £800. Although the printer is delivered on the 16th, the invoice is not received until the 1st of March and the company settles it on 5th March. Using the cash accounting method, this transaction is not recorded until the following month, even though the printer has been up and running since mid-February. The company still owes the £800, but this won’t become apparent in the cash-based method until the following month.
The limitations of cash-based accounting
As we have seen, the cash-based account method is often the right choice for small- and medium-sized businesses due to its simplicity. However, it does have certain limitations, as we saw in the example of the purchase of a printer above.
Another limitation is that a company which uses the cash-based accounting method cannot delay when income is recognised. For example, if the company receives a cheque at the end of one month but doesn’t deposit it in the bank until the start of the next month, it must still be declared in the first month. The company effectively has access to the money represented by the cheque, even if it has not yet cashed it.
The cash-based method also means that any expenses to be declared must actually be incurred during the accounting year in question. It is not possible to include expenses incurred after the end of the financial year, which can result in tax implications.
Cash-based accounting does not tend to suit much larger companies, which often have more complex accounting requirements. Companies with large stock inventories, for example, will find that the cash-based method is not right for them, as it would not give them an accurate picture of their financial situation.
The main limitation of cash-based accounting is that it does not provide an accurate picture of the financial situation of a company insofar as it does not reveal expenses which have been incurred but which have not yet been paid for. A company may have committed large sums of money to a purchase, but those sums have not yet left the account, in which case the company will look a lot more profitable than it actually is.
In the UK, businesses with a turnover of more than £150,000 are required to use the accrual method.
For most small- and medium-sized businesses with a turnover of less than £150,000, the cash-based accounting method is very likely to be the easiest and most relevant method to use. Mooncard provides a simple interface for recording transactions using the cash-based method and can facilitate managerial accounting. In some circumstances, however, accrual accounting might make more sense. It’s worth seeking expert advice to find out which method is best suited to your business. Either way, get in touch with Mooncard for a free demonstration of how accounting software can make your life easier.