How To Record Business Transactions Correctly - Cash Basis Or Accruals?
Is it even possible to record business transactions incorrectly? Is it not just a case of looking at a bank statement and recording all transactions either on a spreadsheet or in accounting software? And why should you bother thinking about it at all?
There are two concepts in accounting
- Cash basis accounting
- Accrual accounting called also traditional accounting
Although you’re not a qualified accountant or a bookkeeper, as a business owner, you should be familiar with the basics. Why? Because you run a business and you’re responsible for any statutory filing with HMRC and/or Companies House. It’s your name on the documents. For example, if you’re self-employed, you need to indicate on a self-assessment tax return that your return is done using cash basis. So, it’s good to have a general understanding of things. But this knowledge will also help you understand your business better and manage it better.
We promise, this article is not going into difficult details for accountants.
What is a difference between cash basis accounting and accrual accounting?
What do accountants mean by cash basis and accrual accounting? The fundamental difference between these two accounting methods lies in the timing of the transactions. Cash basis accounting looks at the actual cash movements. What matters here is when the money cleared in your bank account and when the money left your bank account.
Accrual accounting or traditional accounting on the other hand recognises the transactions in the periods they belong to. When the cash flows into or out of the business is irrelevant.
Let’s look at the example to illustrate this better.
Example
- You raise an invoice to your client on 28 February for work in February
- The invoice has 14 days payment terms
- You receive the money from your client after 10 days, in March.
Cash basis accounting treatment:
As we’re looking at the actual cash in this situation, this business transaction will be recorded in March.
Accrual accounting
The business transactions will be recorded in February because it relates to February work, thus it has to be recognised in that month.
Accrual accounting is more complicated and very often requires certain adjustments when preparing company’s annual accounts (if you run a limited company) and tax returns. If you have an accountant, they will be probably the ones making those adjustments when the time comes. However, as a business owner, you should be familiar with the basic concept, so you understand why your accountant is making those changes. Your accountant will very often need a bit of your help to identify which business transactions need adjusting. You don’t have to worry about a technical side of recording these things in your accounting system as this normally will be covered by your accountant.
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Why is it important how business transactions are recorded?
Whether you’re using cash basis accounting or traditional accounting makes a difference for tax returns. It’s because some transactions can happen or relate to the next financial year. This means the business profits will be showing differently under these two accounting methods. Does it mean you can save on tax with one method or pay more with the other? No, it only means the timing of when you pay tax on something is different.
Who can use cash basis accounting?
Cash basis accounting is very often easier understood by business owners and non-accountants. There’s just no confusion about when the money arrived and left the business. It’s backed up by the bank statements easily as well.
Unfortunately, cash basis accounting can’t be used by everyone.
If you run a limited company or a limited liability partnership, you can’t use cash basis. You have to use more complicated method which is accrual accounting.
If you’re self-employed or in a partnership, you can, but don’t have to, use cash basis but only if your annual turnover doesn’t exceed £150,000. If you decide to use cash basis and at some point your annual turnover goes above £300,000, you will have to switch to traditional accounting.
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