Cash accounting vs accrual accounting

Having access to accurate financial data is critical to building a strong and stable business.

In order for you to have accurate financial data you need to understand the difference between cash accounting and accrual accounting. In this post I’m going to explain why that is and get you comfortable with both.

Before we get into this, let’s just acknowledge the elephant in the room… spending time on your business finances is never top of the list.

It’s pretty hard to get excited about how and where you should account for transactions in your business. I get it.

BUT.

Let’s just reframe this shiz before we dive in.

Because understanding this stuff, getting it right and being able to use the result of it as a killer tool in your business is highly empowering.

And anything that’s empowering in business? Damn sexy.

Think: Beyonce stacking them papers level sexy.

So from this point forward, nailing business finance = BOSS = damn sexy.

K. Let’s get into it.

What do we mean by accounting?

If you’re reading this then I’m sure you’re not new to accounting and why it’s important in your business, but let’s go over it quickly regardless.

In short, accounting is the process of recording every financial transaction that passes through a business in order to keep track of both its financial position and performance.

The timing that’s used for recording these transactions depends on whether cash accounting or accrual accounting is used.

Why should we care about cash accounting vs accrual accounting?

In order to make good decisions about how to manage your business going forward, you need to know how it’s performing.

You need to clearly see what’s working to grow the business and what might be holding you back. The only way to do this is to see accurately what it costs to run the business each month vs how much revenue you’ve earned.

If the timing of transactions is recorded in the wrong way (or even in an inconsistent way) then it will skew the data, making it hard for you to see how things are really going. 

And, therefore, hard to make good decisions about how to manage the business going forward.

In reality a lot of financial transactions have 2 different timings: when the transaction occurs from an operational perspective and from a cash perspective.

What’s the difference between cash accounting and accrual accounting?

Cash accounting is the process of recording transactions based on the timing of the cash movement. Accrual accounting, by contrast, if the process of recording transactions based on when the expensed item is used or the revenue is earned.

Let’s look at an example to explain it better:

Let’s say your electricity bill for June comes in on the 1st July and you pay it on the 15th of July. 

From an operational perspective, this transaction relates to June, as you needed to use the electricity to run the business in June. So, in real terms, it’s a cost for the month of June.

From a cash perspective, the transaction happens in July. So, if you were to use cash accounting here then this cost would get attributed to July.

To look even deeper at this example, the invoice arrived in July too and you’re likely to put the invoice on your system before you pay it. If you were to use that as the main transaction it would also be wrong as it would be applied to July.

This is where accruals come in.

What is an accrual?

In simple terms, accruals are amounts of money that have been spent but not yet paid.

In the example above you have ‘spent’ money on the electricity for June, but just not yet paid cash for it.

An accrual is a transaction you can post to your accounts to show that the expense has occurred. The other side of an accrual (for the double entry) goes to the balance sheet to record the fact that you have liability, i.e. an expense that’s got to be paid soon.

On the flip side, you can also accrue for revenue that has been generated but not yet received.

If the mention of double entry sends you into a tailspin then just ignore that for now. For the purposes of this article it’s not critical to understand.

I’m more concerned that you take away a solid understanding of these concepts as a base.

Prepayments and deferred income

Similar to accruals, these are used to ensure that transactions are accounted for in the correct month, regardless of when the cash movement took place. 

A prepayment is used when the cash has moved (or the invoice has been received) but the goods or services have not yet been used.

An example of this would be a 12 month licence you pay for upfront. In this scenario, you have a big expense in month 1, but you will be using the licence in the business across all 12 months. 

So it makes more sense to split it equally across the months, to show the true cost of doing business each month.

In this case you would record the initial payment as a prepayment, which records it as an asset of the business, i.e. something you’ve paid for and can ‘cash in’ over time.

You then ‘release’ that prepayment over the course of the year, in equal amounts, which simultaneously reduces the asset.

Deferred income is the same thing but for income that you receive, but have not yet earned. An example of this could be ticket sales for an event that is taking place some time in the future.

Why is accrual accounting better?

Using accrual accounting is the only way to see how the business is actually performing period to period. It’s the only way to see what it’s costing to run the business and how much revenue it’s generating, i.e. whether or not it’s profitable.

It’s also the only way to see what could be done to improve the financial performance of the business.

Both of these things are critical to growing a strong, stable business.

Won’t my accountant take care of this?

Short answer: no. 

Longer answer: I’m a chartered accountant and ex-FD and having worked with many accounting firms throughout both my corporate career and through running my own businesses for 20 years… I am yet to find one that will do this for you, correctly, without your constant monitoring and input.

Thus, it’s really important that you understand it yourself.

Some of the reasons for this include:

1. They are working on lots of people’s account all day long, so don’t have the attention to detail that you will have yourself

2. They aren’t as close to the business operations as you and so won’t know when the expense was incurred or revenue earned in the same way that you do

3. They honestly don’t care too much - they’re more concerned that everything is recorded full stop, so that you’re meeting your legal financial obligations

To wrap up

Getting your head around the basics of this concept is important to every business owner. Without it you will struggle to have high quality financial records.

And without these you’ll find it far harder to grow your business than it should be.

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As ever, if you want more hands-on support in launching and growing your business reach out to me about 1:1 coaching. There’s really nothing you can’t do with the right support.