Friday, May 20, 2022

Cash Vs Accruals accounting explained | Why does it matter?

If you are a new startup or early stage small business owner or just run a simple business model then it is likely you are using what is known as the cash-based accounting method this is simply actual money in and out of your business bank account however in accounting there is also an .

Important concept called the accruals method and it is something you should be aware of in this video we will cover as part of a story the following an explanation of cash accounting cash b.a.t accounting what exactly is the accruals concept what are the pros and cons of accrual .

Accounting and finally is the accruals method better or worse for your tax bill sandy's apps is a small freelance business run by sandy who designs and creates smartphone apps for business clients he currently runs the business as a self-employed sole trader on a full-time basis .

Sandy is a solopreneur in the business and does everything himself including designing and creating the apps it takes about one month from the order being placed to delivering the completed app to his clients from the start and in the early days of his business sandy simply used a cash basis on .

Accounting in fact he didn't know any better and his understanding was that cash in was his income and cash out was due to any expenses and costs on average sandy would sell a completed app for 5 000 pounds and would raise an invoice to his .

Client using his cloud-based accounting software once sandy received the money into his business bank account from the client he would merely book a transaction as revenue in his business's income statement he did a google search to find out what it meant by cash accounting .

And found the following description cash accounting is an accounting method where invoice receipts are recorded during the period in which they are received and expenses are recorded in the period in which they are actually paid it all seems straightforward enough to sandy as a month flew by .

Sandy's apps started to grow rapidly orders were flowing in and soon enough sandy could not keep up with everything himself he realized he needed to expand and get help so sandy hired two specialist app developers to help him deliver his orders .

And during this time sandy also decided to get an accounting and tax partner to help him better know his numbers so he could make informed decisions in his first meeting with his newly appointed accountant the accountant established that sandy's app's revenue had hit 80 000 pounds on a rolling 12-month basis .

By the end of june sandy's accountant advised him of his obligation to register for vat should the business exceed the vat registration threshold as sandy's apps were selling b2b that is to businesses that are back registered themselves it made sense for him to register for .

Vat and his accountant julie did this for him so sandy's app started charging vit at the standard rate of 20 and sandy delightfully books the v80 in his accounting software on a cash basis he is in effect using the cash accounting vat scheme and once again sandy does a google .

Search and finds the following description with the cash accounting scheme you can pay vat on your sales when your customers pay you reclaim vat on your purchases when you have paid your suppliers or vatable expenses once again it all seemed quite straightforward to sandy .

He realized his business did not have to pay across vat to hmrc until he received payment including the 20 v80 from his clients and likewise when he actually paid vyot on his expenses and he understood the cash v80 accounting could only be used up to a limit of 150 000 pounds revenue per .

Annum but something was not making sense to sandy quite often sandy's clients took about 60 days or longer to pay sandy and at the same time sandy was playing his staff and all his expenses on no credit term so in other words immediately as incurred when sandy was looking at his income .

Statement for the month of june it looked as though the business was not making any money despite the fact that sandy knew he had completed and delivered five apps in the month at five thousand pounds each plus v80 so sandy arranges a video call with his new trusted accountant .

And he asks him to explain what is going on his accountant spotted the issue quickly and explained to sandy that because his business is using the cash basis of accounting any delays in the invoices paid from his clients will understate his revenue on the income statement in a particular .

Period of time in this case june and because sandy is paying his expenses and suppliers as incurred in other words not on any credit terms his expenses are not matching against his revenue his accountant then suggested switching over to the accruals method of .

Accounting and that this method is quite common for growth businesses this will solve the problem stated the accountant he also pointed out there was a revenue limit imposed by hmrc uk for using the cash basis of accounting that sandy needed to be aware of sandy wanted to do some more of his own .

Research so he did a google search and found the following description their cross concept states that income and expenditure are matched against each other in the period when they are incurred this is sometimes called the matching concept using an accruals approach income is included in the period when the right to .

Receive it is earned sandy then asks his accountant to prepare his june income statement and balance sheet under both the cash basis and accrual spaces as we have already established the business had sold and delivered five apps at five thousand pounds each plus .

Vat providing a total income of twenty five thousand pounds plus five thousand pounds of v80 in the month of june two clients paid up in june a total of ten thousand pounds plus v80 and the other three did not pay until much later in august .

Sandy's expenses amounted to ten thousand pounds for the month of june all on the cash basis so the income statement under the cash basis in june looks like this revenue is stated as ten thousand pounds and expenses as ten thousand pounds so there is no profit or loss for the month under the cash basis of accounting the .

Accountant then presented the accruals method side by side and it revealed 25 000 pounds of revenue and 10 000 pounds of expenses shown a profit in the month of june of 15 000 remember the accruals method allows you to recognize revenue when the right to receive it has been earned .

Exclaimed his accountant as sandy had completed and delivered all five apps in june the business had effectively earned the revenue even though all the money had not yet been received sandy side with relief and finally understood the difference between the two .

Methods the accountant then presented an extract of the balance sheet as of the end of june as also known as the statement of financial position the balance sheet essentially is a snapshot of the financial health of sandy's apps at a point in time under the accruals method there is an asset called accrued revenue .

This represents the fifteen thousand pounds of three clients who had not yet paid by the end of june recognize under the cash method there is nothing at all no recognition of this amount that is owed to sandy's apps the accountant went on to explain the difference is a timing difference .

And it seems simple enough now but as your business grows and you start selling more and more apps the timing difference starts to amplify and can impact your cash flow and tax bill in any given period the accountant went on to summarise that one of the advantages of the accruals .

Method is that it shows a true and fair view of your business finances at a point in time it also shows the full picture on his business's balance sheet and as his business starts to get more complex for example buying equipment and software then .

Concepts such as depreciation are fully accruals based it also smooths out revenue and expenses avoiding sharp spikes and troughs on a month and month basis the accountant did admit that the accruals method was more complex than the cash method and that in its simplicity the cash .

Method was easier to understand and follow he then concluded that the accruals method and the cash method eventually provide the same result over time however how long this period of time is depends on your business for many businesses it takes years to get to the same result .

Sandy now understands the accruals concept better but he wants to know whether the accruals method will be better or worse for his tax bill as a sole trader you pay income tax and class 2 and 4 national insurance on any profits your business generates and don't forget this is done once a year through a self-assessment tax .

Return and to answer this question it really does depend for example if sandy was using the cash base method and by the end of his financial year let's say the fifth of april his revenue was understated then his profit would logically be lower than it should be reported and hence his .

Tax and national insurance bill that year would be lower than it should be on the other hand if he was using the accruals based method and his revenue was overstated for the year then his profit would be overstated and so too would his tax a national insurance bill so in conclusion if your business is .

Operating the cash basis of accountant then it's worth having a chat with your accountant or doing your own research as to whether firstly you are required to switch to across base accounting or if it is beneficial for your business to do so i hope this video has helped you understand the key differences between .

Cash and accruals accounting and why it could matter for you and your business and taking you one step closer to knowing your numbers as always let me know in the comments your thoughts on today's video or if there are any topics you'd like us to cover in the future finally be sure to like and subscribe .

As this does really help us to get our content out there this is tony down draw for the accounting and tax academy thanks for tuning in you

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