FINANCIAL LITERACY • 16 MARCH 2021 • 4 MIN READ
The difference between accrual and cash accounting
You may have heard about financial statements being prepared on either an accrual basis or on a cash basis and wondered about the difference between the two. Well, wonder no more!
When prepared on a cash basis, financial statements include only transactions which went through the business bank account. If you paid some business costs personally, we include those as well.
Income is recognised only when money is received and costs are only recorded when physically paid.
The most common users of financial statements on a cash basis are not-for-profit organisations. They are often not subject to income tax (and don’t need to file a tax return) and are more focused on money coming in and going out.
An accrual set of financial statements is different. It is based on transactions that took place during the year – whether they were in cash or not. Most accounting systems default to the accrual method of preparing financial statements.
Almost all of the financial statements we prepare use the accruals basis. This is not only to meet Inland Revenue tax requirements, but it’s a better reflection of business operations – all income and expense transactions during the period are accounted for. You can’t make your business look better (using a cash basis) by just not paying your bills!
Below are some examples of non-cash transactions.
If you made a sale on 30 March 2021 and sent out an invoice, it’s unlikely you’ll receive the money before year-end (31 March 2021). As the sale itself took place in in the 2021 tax year, we need to account for this income. We therefore record the sale as taxable income and the outstanding amount is shown as an accounts receivable asset (also called debtors) in the balance sheet.
Invoices you receive from suppliers before 31 March 2021, but haven’t yet paid, are another example of a transaction taking place in the 2021 year. Financial statements prepared on a cash basis won’t include that as a cost until the invoice has been paid. Accrual accounting however, does include that cost, whether as an asset purchased or a business expense. As the invoice hadn’t been paid by 31 March 2021, the business has a liability in its balance sheet.
Most assets depreciate (lose value) each year. Think of a motor vehicle – as soon as you drive it off the lot, you’re unlikely to sell it for more than it was purchased. The decrease in value doesn’t involve cash, but needs to be accounted for in accrual financial statements. You may like to read our article “What is Depreciation?”, written by Beth, one of our non-accountants.
Accrual accounting factors in the depreciation concept and each year, we can claim depreciation as an expense. Financial statements prepared on a cash basis will not show this decrease in value. The asset will continue to be shown at its original cost.
When preparing financial statements for tax purposes, we claim depreciation using the maximum rates permitted by Inland Revenue.
Gains or losses when selling an asset
As mentioned above, depreciation rates are set by Inland Revenue. Those rates may not reflect the exact reduction in asset value each year.
When you sell the asset you’ll receive cash. This isn’t income. Instead, we sell the asset from the asset register. If you have received less than the asset’s book value*, the business will have a loss. If you receive more than the asset’s book value, you’ve claimed too much depreciation in the past and need to pay it back.
Cash accounting will only show the sale price (money coming in).
* The book value is the original cost less all depreciation claimed from the time the asset was purchased
Profit and loss account on a cash basis
Accounting systems will often have the option of running the profit and loss account on a cash or accrual basis.
If you use Xero, we’ve included the relevant steps below needed to generate your profit and loss account on a cash basis. These steps come from Xero’s instructions on how to prepare a profit and loss account.
- In the Accounting menu, select Reports.
- Under Financial, click Profit and Loss (New).
- Set Date Range.
- Click the settings icon for additional options.
Select an Accounting basis, either Accrual or Cash
- Click Update.
Just note that the report will always default back to Accrual. You’ll need to select Cash next time you’d like to see the report.
…you can also take a look at Xero’s Cash Summary report. It shows a summary of all cash transactions, not just those affecting profit.
When preparing financial statements used to complete tax returns, we’ll always use the accrual form of accounting. Why?
Your statements must comply with the following accounting principles:
- double entry method of recording transactions
- accrual accounting
Because Inland Revenue tells us to and because this is the standard accounting method used throughout the world for ‘for-profit’ businesses.
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