Bookkeeping based upon cash accounting principles is the
easiest accountancy practise but not necessarily the most
accurate or beneficial for tax purposes for the business.
This is because cash accounting adopts the date of
financial documents such as sales invoices and purchase
invoices as the automotive date for those primary financial
records to be entered into the accounts.
The date entered on the sales or purchase receipt is called
the tax point. The tax point does not determine the spread
of that transaction over the tax period which can be
different when accounts are prepared on an accruals basis
as opposed to a cash basis.
For the purposes of cash accounting the effective inclusion
of the transaction in the financial records is the date the
cash or bank receipt or payment was made. The tax point
date on the document is not the deciding factor to include
the item in the accounts. The determining factor is the
date the transaction amount was received or paid out be
that in cash or bank.
There are disadvantages to maintaining accounts on a cash
basis in that records must be kept of all payments received
and paid out and those records supported by the actual
primary accounting documents to which they relate. That
entails matching the financial documents to the payments
and receipts records, a feature many small businesses might
find onerous.
Virtually all professional accountants adopt an accruals
basis for clients accounting purposes as it is based upon
recording all financial information whether relevant to the
tax period or not and then adjusting the management
accounting profit indicated to produce the net taxable
profit or loss.
By operating an accruals basis all financial documents are
recorded according to the tax point date. If all financial
transactions during the year were paid for in that year
then the cash basis and accruals basis would produce
identical results.
The main adjustment a small business or the accountant
might make to accounts prepared on the accruals basis is to
first prepare the set of accounts according to the tax
point of the primary accounting records and then examine
those transactions and adjust them according to their
relevance to the financial period for which the accounts
are being prepared.
A typical example of the difference would be the rent
invoice for the business premises. Let us assume a
quarterly rent invoice was received dated 1 December for
the 3 months from December 1 to February 28 which was paid
by the small business owner by cheque on December 31 and a
year end date also of December 31
On a cash basis the rent would not technically be included
in the accounts as it would be shown as a rent payment from
the business bank account on January 2 or later if cashed
by the recipient at a later date. Therefore that quarters
rent would be included in the following year accounts not
the current year as issuing a cheque is not a payment but
actually a promise to pay.
If the rent was paid in cash prior to the 31 December then
the whole 3 months rent would be included in the current
accounting records. That treatment may have distorted the
accounts as more or less than 12 months rent might have
been included in the tax calculations.
On an accruals basis the rent invoice would have been
entered in the accounting records with an effective date of
December 1. Using accrual accounting the accountant or
small business owner preparing the accounts would then
deduct 2 months rent as a prepayment leaving one months
rent in the current year accounts.
That is more accurate as the other side of the accounting
would be for that same accountant or bookkeeper to further
include the 2 months rent not already claimed to be
included in the tax calculation for the next financial
year. That is how prepayments are treated when a business
uses the accruals accounting basis.
Further when using the cash accounting basis only those
transactions paid for or received are included. On an
accruals basis additional expenses can be added that may
not have even been invoiced yet on the basis that the costs
incurred were relevant to the accounting period for which
the books are being prepared.
Cash accounting might appear easier but has the
disadvantage of maintaining receipts and payments records
in addition to the primary documents which should also be
matched to the financial transactions to support the
accounts.
Accrual accounting is based upon recording all financial
transactions and then adjusting the end result to determine
the most accurate net taxable profit. The accruals basis is
favoured by accountants as it reaches an accurate tax
liability as opposed to more or less tax being payable on
the cash basis according to the credit control policies and
practises of the business its suppliers and clients.
----------------------------------------------------
Terry Cartwright, accountant and CEO at DIY Accounting,
designs accounting software http://www.diyaccounting.co.uk/
on excel spreadsheets providing complete single and double
entry bookkeeping systems
http://www.diyaccounting.co.uk/bookkeeping.htm
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