The way to success for startups is challenging, and it needs time, effort, a second thought on every step, a legal structure, a good business plan, and accounting. When we speak about accounting for startups, we mean everything from recording financial data, preparing financial statements, and making sound decisions, to paying taxes and everything in between.
But, the first step to accounting is always choosing the proper accounting method for your business. It is mainly of two types: Cash-based and Accrual-based. The type of accounting method you choose will define your startup’s success.
This comprehensive guide will cover everything about the two popular accounting methods. However, if it still sounds confusing, look for a self-employed accountant for startups UK.
Table of contents
Understand accrual-based accounting
In accrual-based accounting, it doesn’t matter whether money changes hands. You record an expense when it is incurred or revenue when it is earned.
A revenue is mentioned as accrued revenue and an expense as an accrued expense until the cash is transferred to complete a transaction.
Myra buys raw materials of £1,000 from a supplier. She records the invoice date on the books as “accrued expense” under the accounts payable part. No money is paid! The £1,000 debt is recorded as a liability on her company accounts.
John sells equipment for £1,000 and issues a bill. The date on the bill is recorded on the books as “accrued revenue” under the accounts receivable column. No money is paid! The £1,000 sale is entered as assets on company accounts.
● It gives a more realistic idea of your revenue and expenses in a particular period.
● It gives a long-term picture of a business performance
● It showcases the accurate picture of your financial position
● It helps you make productive financial decisions
● Allow you to make immediate feedback on the business cash flows
● Assist in managing the current resources
● It is difficult to monitor the cash flow inviting potentially devastating consequences.
● It is complex in comparison to cash counting and is expensive to implement
● It demands careful monitoring of your invoices
● At times, it may result in short-term cash flow issues
Understand cash-based accounting
In cash-based accounting, you can only record an expense or revenue when money changes hands. It means you can record an expense when you are making a payment by hand and revenue when you receive a payment.
Robert & Sons sells a premium flower vase and issues a bill to a customer. They don’t record the bill date on the books, and the entry is made with the date when the customer pays them.
Similarly, the company might have purchased the flower vase from a manufacturer and received an invoice. They won’t enter the transaction as an expense unless they pay the amount and record the payment date, not the billing date.
● It is simple to maintain and easy to determine a transaction
● It helps in tracking the amount of cash your business has at a particular time
● Your business income isn’t taxed until you receive or pay cash
● Calculating tax and VAT is easy
● It doesn’t recognize accounts receivable or accounts payable
● You have limited information to make sound decisions
● It is not suitable for a complex business structure like an unlimited company
● You find difficulty in getting funds as most banks ask for accounts using traditional accounting
● It may overstate or understate your business conditions
Difference between cash and accrual accounting
The difference between cash and accrual accounting methods are listed below:
Should startups use cash or accrual accounting?
Cash accounting is suitable for startups making £150,000 or less in a year in the UK. However, your business structure must be either a sole trader or a partnership.
Startups can use cash basis accounting as they are simple and easy to understand and allows you to track and manage cash flows easily.
But, a limited company in the UK must use accrual-based accounting in business.
To use cash accounting in business, you must inform HMRC, or they will assume you’re using accrual accounting. But if you are aiming for fast business growth, it is good to adopt accrual accounting from your initial years.
However, choosing an accounting method depends on numerous factors like business size, financial complexity, and preferences. As a startup, you can choose anyone, but when a business starts earning more than £150,000 or is registered as a limited company, they have a single choice: accrual accounting.
You must carefully choose an accounting method for your startup in the UK. Learning the difference between cash and accrual accounting methods will help you make the right choice. However, you can always ask for advice from experts who understand your industry and can develop excellent solutions.