There are two types of accounting methods and it is almost up to you, to decide which you use. The difference is purely how a company records the ins and outs of the finances of the business. Many large companies try to use the subtle difference to manipulate their numbers and this has led to many financial scandals.
Cash accounting is the method where you record your income when you actually receive it in cash or in to your bank. For example, if you do a job and invoice it on 1st April 2017 but you don’t receive the money until 30th April 2017, it crosses over two tax periods (if you’re a sole trader with a year-end of 5th April). For tax purposes, you wouldn’t include it until the following year and the same for your purchases, if you order some items, stock for example, on the 1st April but you don’t pay for it until 30th April, then it wouldn’t be included until the following year. Small companies and sole traders tend to use this method as it is easier and you don’t necessarily need an accountant to calculate your profit and loss but you will still need an accountant to complete your tax return as there may be more allowances you could use to reduce your tax.
Accrual accounting is the method where you record the transaction as you raise the invoice to your customer or you receive an invoice from a supplier. Normally you would pay the invoices after a period of time, generally 30 days after the date of the invoice and your customers would also have a small grace period before having to pay you. Making your terms clear at the outset should help your customers know when you expect payment however, you will also need a robust credit control system to ensure that payment due to you doesn’t become so overdue that it causes you cash-flow problems. As a rule, incorporated companies with a turnover of above £150,000 must use this method. If you start the year anticipating your turnover to be below that and you use the cash accounting method, you can continue to use it as long as your turnover doesn’t rise above £300,00 BUT the following year you must use the accrual method.
Why does it matter which method you use?
The method you use can have a major impact on the revenue a business reports and the expenses it incurs to calculate their bottom line.
Using the cash accounting method often makes it difficult to match up paperwork. It also means that you could do a large piece of work and not be recognised for us for a month or so afterwards. One benefit is however, it is closer to showing you the actual cash available.
The accrual method is easier to match your paperwork and providing the business a better idea of how much they are spending and how much profit it’s making. Purchases are recorded, or accrued, in the month of purchase even if you haven’t paid for it yet and the same for your sales.
What does this mean for small companies? By using the cash accounting method, you could ask your customers not to pay you until after your year-end, especially if it has been a large project/sale, that way you wouldn’t pay any tax until the following year, this is of course on the proviso that your cash-flow can sustain the wait for the money, likewise you could pre-purchase any stock before your year-end reducing your liability by recording higher expenditure, again on the proviso that your cash-flow can sustain you spending money before your customer has paid you.
Before embarking on any method, we would advise that you speak to your accountant to get the best possible advice for you and your business.