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.
Author Resource:-
Terry Cartwright, CEO DIY Accounting, a qualified accountant in the UK, designs Accounting Software on excel spreadsheets and Payroll Software for small to medium sized business providing a complete accounting solution and also supplies Company Formation packages for new limited liability companies
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