Accrual Accounting is one of two methods of keeping your financial records. Its main feature is that you make an entry in your books when you make a deal, not when cash actually changes hands.
Let's take Jack who works as a copywriter as an example:
Using the accrual method of record-keeping, Jack the copywriter considers his income earned once he agrees to take on the service and issues an invoice. It doesn’t matter when he gets the money. Similarly, he will record an expense in his books when he receives an invoice from a supplier that he committed to.
Generally Accepted Accounting Practices list by the Financial Reporting Council recommends businesses to use Accrual Accounting as opposed to the Cash Basis Accounting.
The difference between the Accrual Accounting and the Cash Basis Accounting
Cash Basis Accounting has the opposite approach: transactions are recorded once payment is received or paid.
If Jack used the cash-based method, he would consider his income earned only once he gets the money.
ZCash Basis Accounting is not for everyone. The method can only be used by businesses with a yearly turnover of less than £150,000. LLC’s, LLP’s, and publicly traded companies are prohibited to keep track of their finance this way. On top of that, there are some industry limitations. You can find more information on that in our Cash Basis Accounting article.
Cash basis vs. Accrual basis
There is a guy named Edward who owns Christmas decorations online shop. Let’s take a look at his transactions:
- He sold £30,000 worth of goods on January 1st but received the money for it on March 30th.
- He Purchased stock of £8,000 on January 1st and paid it the same day
- His website maintenance invoice came in on March 15th. He paid it on April 15th.
- His marketing guy sent him an invoice on February 1st. Edward paid it the same day.
Let’s take a look at his P&L at the end of the first quarter of 2020. It’s recorded using both methods.
|Particular||Cash Basis||Accrual basis||Transaction Date||Payment/Receipt date||Notes|
|Sales||0||30000||01/01/2020||30/04/2020||Under the cash basis, the sale was not reported until Edward got the money on 30.04.2020. But under the accrual basis, as soon as he earned the deal, he recorded it.|
|Website Maintenance||0||-1000||5/03/2020||15/04/2020||Under the cash basis, the transaction is recorded when payment is made to the supplier. Cash is paid after the reporting period and therefore not recorded.|
|P&L||-14000||15000||-||-||Under the cash basis, it seems as if Edward made a loss of £14,000. In reality that is just a cash position of the business. On an accrual basis, the £30,000 in sales are recorded right away and P&L shows £15,000 in profit.|
If you run a small business, cash basis accounting may suit you better than accrual accounting. It’s easier to see how much tax you need to pay on the basis of the cash you received and paid for example. This helps to avoid paying tax on sales for which you have not received the cash yet.
At the same time, the cash basis may not be suitable for you if your company holds a high level of stock. In this scenario, your books state mostly losses since there is no cash profit before you move some of the stock.
Using accrual basis can be difficult in certain scenarios and the bookkeeper/accountant needs to pay a bit extra attention to the books. There is a risk to record a sale prematurely. If it happens at the end of an accounting period, you risk paying more than you have to in taxes, for example.
The accrual basis might suit you better if you show your books to, say, a bank for loan approval. In the case of Edward, if he went to the bank with £14,000 losses compared to £15,000 profit, his claim would be weak.
On top of that, today the strongest side of cash basis is not that strong anymore. You can just as easily check your balance with a couple of clicks, thanks to advanced and available accounting software.