What is the difference between cash and accrual accounting?

When keeping your accounts records you can choose whether to record your transactions on a cash or accrual basis so it is important to understand these terms when it comes to understanding your finances as they can each give a different picture of your business for the same period.

Recording transactions on a cash basis means literally recording the "ins" and "outs" as they occur.  This is the simplest way to keep accounts records but this may not reflect accurately the income earned or expenses incurred during a month.  This method will only show the monies received and the payments made and this could very easily distort the picture of how your business is doing if not many of your customers have paid during the month or you have had to pay out a lot of expenses.

Recording transactions on an accrual basis means recording invoices from suppliers, as well as the invoices you raise for customers, using the date on the invoice.  The transactions are therefore recorded on the date they occur and not a date in the future when a payment is made.  This basis gives a more accurate view of the work you have completed (invoiced) during the month and the expenses you have incurred.  However you should bear in mind that the supplier invoices may not necessarily relate to the sales you have made that month.   If you buy stock to sell, for example, it is unlikely that you will sell all the stock you have bought in the month you bought it.

As your business grows it will be important to have a customer ledger and a supplier ledger showing the invoices which are outstanding.  This will also give you a record of how your customers pay; which ones pay promptly and which cause you a lot of wasted time chasing payment. (If all your sales are immediate payment you will not need a customer ledger because there will never be a problem with unpaid invoices.)  Having a supplier ledger will also enable you to keep track of invoices received and the date you paid them for each supplier.  An accurate record will help reconcile what you have received and paid with the supplier's statement.

When your business gets to the stage where you want to see regular financial reports, using the accrual basis for your accounts will ensure the figures you are seeing are actually the income and expenses for that period.  Your monthly profit and loss report won't be a true reflection if you use the cash basis and have received lots of income in one month but paid out very little, and equally if you have made a lot of quarterly payments like rent, electric or gas in one month your profit could look very disappointing.  You could say it's "swings and roundabouts" but ensuring expenses are recorded in the month they occur and income in the month it was invoiced will give you a much better picture of how your business is doing.

It is important, therefore, that you decide how to record your transactions and to be consistent with the recording without being too extreme.  For example regular monthly direct debit payments for mobile phone, car tax, etc don't need to have an invoice added as there will be one payment in every month.  

We produce regular monthly financial reports for many of our clients who are keen to keep track of their turnover and costs as well as their net profit and gross profit margin.  We keep accounts for these clients on an accrual basis so the reports are as accurate as possible.  We do have clients who aren't bothered about reports but we still use the accrual basis because of the nature or size of their business.  Sole traders generally bring their accounts in once or twice a year so cash basis accounting is ideal for them.

If you would like to receive regular management reports from your accounts which are recorded in a way which give a true reflection of how your business is doing from month to month, give us a call.  As long as you provide us with the information we need to complete your accounts regularly we can produce accurate monthly reports which will enable you to see how your business has been developing and to make plans for the future.