- 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 VAT accounting,
what exactly is the accruals concept?
What are the pros and cons of accrual accounting
and find is the accruals method better 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 merrily book the transaction as revenue
in his businesses income statement.
He did a Google search
to find out what you 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 App 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 specialists 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.
And 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 the VAT
should the business exceed the VAT registration threshold.
As Sandy's Apps were selling B2B,
that is to businesses that are VAT registered themselves,
it made sense for him to register for VAT
and his accountant, Judy, did this for him.
So, Sandy's App started charging VAT
at the standard rate of 20%
and Sandy delightfully books that VAT
in his accounting software on a cash basis.
He is in effect using the cash accounting VAT scheme.
How once again, Sandy does a Google search
and finds a following description.
With a 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 all 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% VAT from his clients.
And likewise, when he actually paid VAT on his expenses.
And he understood the cash VAT accounting could only be used
up to a limit of 150,000 pounds of 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 terms.
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 5,000 pounds each
plus VAT.
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 bases
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, 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 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 accounting
that Sandy needed to be aware of.
Sandy wants to do some more of his own research.
So he did a Google search
and found the following description.
The accruals concepts states 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 accruals basis.
As we have already established,
the business has sold and delivered five apps
at 5,000 pounds each plus VAT,
providing a total income of 25,000 pounds
plus 5,000 pounds of VAT in the month of June.
Two clients paid up in June,
a total of 10,000 pounds plus VAT.
And the other three did not pay until much later in August.
Sandy's expenses amounted to 10,000 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 10,000 pounds
and expenses as 10,000 pounds.
So, there is no profit or loss for the month
under the cash basis of accounting.
The accountant then presented the accruals methods
side by side and it revealed 25,000 pounds of revenue
and 10,000 pounds of expenses showing a profit
in the month of June or 15,000 pounds.
Remember, the accruals method allows you to recognize
revenue when the right to receive it has been earned,
explained 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 sighed 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 15,000 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 different starts to amplify
and can impact your cashflow and tax bill
in any given period.
The accountant went on to summarize
that one of the advantages of 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
and concepts such as depreciation are fully accruals based.
It also smooths out revenue and expenses
avoiding sharp spikes and troughs on a month by 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 across method and the cash method
eventually provide the same result over time.
However, how long this period of time is
depends on your work 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 across method
will be better or worse for his tax bill.
As a sole trader,
you pay income tax and class two and four 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-based method
and by the end of his financial year,
let's say the 5th 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 to what he's taxed at national insurance bill.
So in conclusion,
if your business is operating the cash basis of accounting,
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 accruals-based 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 Dhanjal for the Accounting & Tax Academy.
Thanks for tuning in.