How to use cash accounting and accrual accounting

When you start a new business, you need to make a lot of a important decisions, from choosing the right name for your company to how to define your audience. One of the most important decisions you’ll make is whether to use cash or accrual accounting.

But what are cash accounting and accrual accounting, and how do you know which one to choose?

The matching principle in accounting

The matching principle is one of the fundamental accounting principles. According to the matching princple, revenues and related expenses should be recorded in the accounting period that they incur.

The matching principle is intended to give a more accurate picture of a company's current financial status by recognising expenses when they are incurred and distinguishing between deferred and accrued revenue.

Understanding the matching principle is key to understanding cash and accrural accounting - whereas accrural accounting follows the matching principle, cash accounting does not.

How to use accrual accounting

Accrual accounting is a common accounting method for larger businesses. Accrual accounting requires transactions to be recorded in the accounting period in which they occur - regardless of when the payment is made or received.

For example, a furniture manufacturer sells some chairs for £1,000 to a retailer at the end of March (quarter 1). The retailer pays in April (quarter 2). The manufacturer should record £1,000 under accounts receivables (debit) in quarter 1. When the £1,000 payment is received in quarter 2, the company should adjust their entry.

If you choose to use accrual accounting, you should be aware of the impact this can have on certain tax thresholds and allowances such as the Personal Allowance or the threshold for VAT registration. Because transactions are often recorded before payment is made, you could end up paying tax on income that you haven't yet recieved.

How to use cash accounting

Cash accounting is a method of accounting that is more commonly used by small businesses or self-employed workers than large corporations. Cash accounting challenges the matching principle by only recording income or expenses in the period that money changes hands.

Using the same example of the furniture manufacturer, the £1,000 sale would be recorded under accounts receivables (debit) in quarter 2.

Because income and expenses are recorded when money changes hands, rather than when transactions occur, cash accounting is a more simple form of recording financial transactions that might be easier to understand for business owners or freelancers without a financial background.

However, cash accounting does not always provide the most accurate overview of a company’s financial status because it doesn’t include accounts payable or accounts receivable. Cash accounting could therefore lead to an over- or under-estimation of a company’s value.

Managing your accounting practices with Debitoor

Both cash accounting and accrual accounting are methods that require attention and a certain level of control. Invoicing software like Debitoor not only allows you to create invoices quickly and easily, it also gives you the tools you need to manage your business accounts.

When you create an account with Debitoor, you can choose whether to use cash or accrual accounting. Whenever you generate a financial report, your income and expenses will be recorded according the accounting method you choose.