When you just start operating as a business, it is important to choose the right accounting method to record revenue and expenses.
There are two different methods: cash basis and accrual or traditional accounting.
Cash Basis Accounting Method
It is the simplest and easiest accounting method and often used by small businesses. Under this method, you recognise revenue only when you receive money from your customers and expenses when cash is paid out.
The main advantage of this method is that you do not have to pay Income Tax on the money you have not earned yet in your accounting period. In other words, you do not include in your revenue any money you are owed but have not yet received.
As regards expenses, you only include the expenses you actually paid for.
Here are two examples of how you need to recognise revenue under cash basis method:
John is the owner of a sports equipment store. On 31 March 2016 he sold 100 basketball balls to a local team. He had purchased the balls for £10/each and sold them for £20/each. He made a profit of £1,000. John recorded the revenue of £2,000 and the expense of £1,000.
On the same day, he also sold 100 baseball balls to a baseball club. However, they promised to pay in seven days. John had purchased the baseball balls for £5/each and sold them for £15/each. He could have recorded the revenue of £1,500, but he can only recognise this revenue once he receives the money from the baseball club.
This is a very simplistic example, however, it shows that under cash basis method your cash flow can be negative, and it does not show a realistic picture of your total revenue.
You can use cash basis if you are a small self-employed business, for example, a sole trader or partnership and you have an income of £83,000 or less per year.
This method may not be suitable if you run a complex business, for example, you have high levels of stock or you need to get finance for your business.
Limited companies and limited liability partnerships cannot use cash basis.
Accrual Accounting Method
The main difference between cash basis and accrual method is that revenue and expenses are recorded by the date you invoice or you are billed. This means that your customers can pay you later for your services or goods but you can still record it as revenue.
Let’s go back to John’s example: this time John is using accrual accounting method to record his revenue.
As you can see, now John can record the total revenue of £3,500 for two sales.
This method is more reliable as it shows a fuller picture of a company’s performance, its profits and revenue that is actually earned.
Under this method, a business owner has to keep track of cash flow as a company’s income statement can look great but with no cash in the bank if customers are slow to pay.
As your business grows, cash basis accounting may not be suitable for your business needs, and you would need to switch to accrual method to accurately track revenues and expenses of your business.
With this simple example we wanted to show you that you, as a business owner, had a choice of two accounting methods you could use for your business. If you want to be confident in your choice, it is always a good idea to consult a professional accountant.
