Acrrual basis vs cash basis

Accrual vs Cash Basis Accounting Methods – Everything You Need To Know

“Accrual” is one of those words that sounds scary to the uninitiated but is like bread and butter in bookkeeping and business finance.

With the help of this article, you’ll be able to get to grips with it quickly.

The difference between an accrual vs a cash basis method has ramifications on how you report on your business performance which every business owner should be aware of.

These methods are simply two different ways to record your business transactions. 

Accrual-based accounting

Records the value of a transaction on the date an invoice is issued. 

Cash-based accounting

Records the value of a transaction on the date cash is received.

What’s the difference?

The difference between the two is all down to the timing of invoices compared with the timing of cash payments, for those invoices.

Accrual-based accounting focuses on lining up transactions with when they are earned whilst cash-based accounting focuses on when the cash actually hits your bank account.

It’s all about timing. 

Recording transactions

A transaction is an exchange of goods or services for monetary value. 

When we talk about recording, we refer to the transcription of these financial transactions into your general ledger.

This complete record is used for reporting on and analysing your company performance over time. 

Related: What’s the Difference Between Debits and Credits in Accounting?

Clearly the method you use to record transactions is going to have a strong influence on the financial results you report each month, quarter and year.

So, let’s unpack this a bit further. 

What does this mean for my business accounts?

For many businesses, the method they choose can have a dramatic impact on the figures. For others, there might not be much difference.

It all depends on the type of transactions the company deals with. 

Businesses that invoice and receive cash at the same time

Businesses that receive cash immediately with each transaction, won’t see many variations between the two methods. The date of the invoice and the receipt of cash is effectively the same.

A customer visits a coffee shop and purchases a £2.50 latte handing the cash over immediately.

In this transaction, the date the revenue was earned and the cash was received is the same.

Here the accrual and cash-based accounting records would be identical. This is quite typical for smaller purchases and many businesses operate like this.

However, even if the sales side of your business deals with immediate cash transactions, you’ll likely transact with suppliers that don’t.

For example, purchasing inventory, paying for rent and other bills often have very different cash timing to invoice timing.

So, even if a business’s sales largely operate on immediate cash receipt, most businesses will still see some difference between these two accounting methods.

Related: 18 Actionable Cash Flow Forecasting Tips for Small Businesses & Startups

Businesses that invoice first and receive cash later

It becomes more pronounced for businesses that do have a lag between invoice and cash on their own sales.

Many businesses sell products or services with 30, 60 or 90-day payment terms (or even more complex arrangements). This means the customer can receive the product or service but pay at any point during this period, potentially adding a large degree of variation between invoice timing and cash timing. 

You see this a lot in companies selling large ticket items like furniture or vehicles. They often provide credit options giving the customer more palatable cash terms, delaying or spreading out the impact on their bank balance.

Service-based companies such as plumbers, builders, electricians and the like will almost always invoice a customer for work completed with the actual exchange of cash occurring later. 

Consultants and agencies for various industries might operate by splitting the invoice amount. Some cash would be due in advance of work and some on completion. 

As you can see there are a myriad of ways that the timing between invoice and cash receipt can vary. 

Accrual accounting recognises what you’ve earned

Now we’ve run through the basics behind the accrual method, we can delve into the purpose behind the system. 

The accrual accounting system aims to record revenues and expenses when they are earned

When you do something of value, the accrual system recognises that effort at the time it occurs.

The cash-based method only recognises your efforts when the cash comes in.

As we’ve seen, this could be quite disconnected from the event it relates to.

To put it more formally:

When your company provides (or is provided with) goods or services of value, this value should be recorded at the point of provision

The point of provision is key.

Let me give you a more complex example to demonstrate why:

A web design company building a website for a client quotes £4000 for the project.

They might agree with the client that they pay £1000 in advance and £3000 on completion.

The project takes 4 months, starting in January and ending in April. 

The cash-based method records £1000 received in January and £3000 received at the end of April.

This does not reflect exactly when this money was earned in reality though. 

January was spent mostly with planning meetings. Very little development hours were undertaken by the development team. 

In February, planning was mostly complete and the entire team began working at full pace through February and into March.

By the start of April, the project was nearly finished. The web company and their client went back and forth with some final tweaks before completion.

In terms of the hours logged and the value of work earned in those periods it looks more like this:

January: £250

February: £2000

March: £1250

April: £500

The point of provision, in this case, is spread out over time. 

If you reported on the figures for this period, the cash-method would give you no indication of the progress on this project.

The accrual method gives you an indication of how much money your team has actually earned.

Recording just the cash here would be simpler but the accrual method is more indicative of business performance.

It comes back to the type of business and how they transact which affects how important this accounting method is to your company. 

Consider a property development company spending hundreds of thousands of pounds on material and labour for months on end developing a new site. 

If they used a simple cash-based method to record their financial results, they would show massive losses that wouldn’t fairly reflect the work undergone. 

So I’ve talked about reporting on your figures a few times in this article already.

What reports do you use for analysing your transactions and how are they impacted by the two different methods?

Reporting transactions on your Profit & Loss statement

The Profit & Loss statement is the standard report for measuring your businesses performance. 

It organises your revenues and expenditures into categories for you to analyse and compare between periods.

The two accounting methods will show transactions falling into different periods on this report. 

Some transactions might appear lumped up in the cash method but spread over several periods in the accrual method (or vice versa!). 

If you use accounting software and record both invoice dates and cash received dates, then you could generate two P&L statements for both methods. As we’ve seen in the earlier examples, they will reveal different information about your business – both being insightful. 

The cash method is usually easier for small businesses to record and report on since the information naturally falls out of bank account statements.

It can lead to misleading results on your P&L though.

The Profit & Loss is intended to highlight when the business is performing profitably or performing at a loss.

You could influence this result and appear profitable in a period because you didn’t pay your bills on time! Clearly, that’s a bit misleading.

Likewise, your team might have logged hundreds of hours of work towards earning revenue but this doesn’t get recognised because you have not received any cash for that work yet. A cash-based profit & loss would show an unjustified loss for this period. Hardly fair! 

Generally, once a business reaches a certain scale and has more resources to put into financial operations, they will use the accrual method. It’s more intensive to record, maintain and report on but it’s also a truer picture.

A Profit & Loss reported generated on an accrual basis gives the decision-makers better information on real business performance. Revenues and expenditures are lined up to the point of provision of the goods and services.

The recorded value of a transaction more accurately reflects the work done in the real world.

This also gives you a more accurate picture of your profit margins which is key to understanding how efficiently your business is running.

Related: Gross Profit vs Net Profit – What’s the difference? (Examples + Forumlas)

A separate Cash flow statement is then generated to complement this report.

All businesses still need to keep a close eye on cash inflows and cash outflows to ensure they aren’t in danger of running out of money.

A business can be profitable and still run out of cash!

Ultimately, your cash flow decides whether you can survive in the short term but your profitability decides whether your business can work in the long run.

Your business model has to result in a company that can operate with sufficient margins to support its operating activities.

This is highly relevant when it comes to financial forecasting too. Short term cash flow forecasts help ensure you don’t run out of cash. 

Long-term cash flow forecasts give you a more strategic view and help you decide when to invest into your business.

Accrual-based P&Ls forecasts help you explore your business model into the future to find ways to improve your profitability (and breakeven if you are still searching for profitability). 

For the complete picture, a management team can also look at accounts payable and accounts receivable reported on the balance sheet statement

This will show you the total of invoices and bills in circulation that have not yet been paid.

With this final piece of the puzzle you get the full financial loop on your transactions:

  • Profit & Loss statement (accrual basis): shows the value and date of invoices/bills 
  • Cash flow statement: shows the value of cash paid for invoices/bills so far
  • Balance sheet statement: shows the value of invoices/bills not yet paid
Ultimately, your cash flow decides whether you can survive in the short term but your profitability decides whether your business can work in the long run.Click To Tweet

 

What are the pros and cons of each method?

Cash-based pros:

  • Quicker process – you can read your results straight off your bank statement
  • Easier to understand 
  • Helps with the most important short term concern – not running out of cash!

Cash-based cons:

  • Doesn’t reflect real business performance
  • Can impact your profitability
  • Harder to make strategic business decisions
  • Investment applications may require accrual-based records

Accrual-based pros:

  • Presents a better reflection of your business performance
  • Easier to see your real profit margins
  • Easier for decision-makers to act on

Accrual-based cons:

  • More work to record and track
  • Can be more complex to understand
  • Still requires you to generate cash-based reports to ensure you don’t have cash flow problems

In the end, you might not have a choice! Your country’s policies may require you to use the accrual-based method.

As of writing, the UK requires businesses with a turnover greater than £150,000 to use the accrual system.

However, many startups will begin using the cash method.

For startups, time and resources are limited and anything that can simplify operations is welcome.

As you progress in scale and complexity, you’ll find the accrual method becomes more and more desired for decision making and understanding your businesses journey. 

Further reading and resources

If you’re a business owner looking to become a wiz at finance or an accounting learning more about your profession, we’ve got a wealth of resources to help!

Of course, we also specialise in financial forecasting and scenario modelling – the key to exploring the future of your business. 

Accounting basics:

Report format examples:

If you’re comfortable in the world of spreadsheets, our templates will help your get started building financial forecasts:

Want to forecast your business? Check our beginners guides:

Make sure you check out our jargon buster if you’re tripping up on any of the financial terminology:

Financial Terms Jargon Buster – A Simple Glossary

Finally, if spreadsheets aren’t your thing, or you are looking for a forecasting tool with a bit more oomph you should try our very own financial forecasting software, Brixx! 

It generates a detailed Cash flow, Profit & Loss and Balance Sheet statement for you (through simple inputs). But that is just the start, Brixx is a modelling tool that enables the rapid exploration of future scenarios to super power your decision making process. 

Just like our blog articles, we build software that is simple and approachable ready for anyone to jump and get up to speed quickly.

Sign up for your free 14 day trial today!

 

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James Beer 28th July 2020 By
 

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