In order to fully implement accounting practices, businesses need to continue with choose the accounting method they ‘re going to follow. Companies are free to select among two specific accounting methods: the cash basis for accounting, or the accrual basis for accounting.
In general VAT is calculated on the basis that the VAT you pay to your suppliers is deducted from the VAT you collect from your clients (Output VAT). This then becomes your VAT liability, or in the case where you’re paying out more VAT than you’re collecting this is the sum you would reclaim from HMRC.
So let’s break down the two most popular methods for VAT accounting. Typically, accrual accounting is preferred over cash accounting, and indeed required with higher turnover businesses.
What is Cash Basis?
Record transactions only when cash is actually received or paid
What is Accrual Basis?
Record transactions when it occurs, even if cash is not received or paid
Use Case for understanding:
Consider a situation where you purchased 250 units of a product and will pay for it coming month. In cash basis, there will be no transactions recorded where as in Accrual basis, transactions recorded through an accounts payable(liability) account.
Note: According to IFRS, a liability is a present obligation of an organization arising from past events, and the settlement of which is expected to result in an outflow of economic benefits.
What are the differences between Cash and Accruals?
- Recognizes revenue when cash has been received
- Recognizes expenses when cash has been spent
- Taxes are not paid on money that hasn’t been received yet
- Available only if your taxable turnover is less than £1.35 million (2018 threshold).
- Recognizes revenue when it’s earned (eg. when the project is complete)
- Recognizes expenses when they’re billed (eg. when you’ve received an invoice)
- Taxes paid on money that you’re still owed
- Mandatory if your taxable turnover exceeds £1.35 million (2018 threshold).
Most small to medium-sized companies will use the cash accounting method when registering for VAT. You can still switch approaches later, but you need to keep HMRC informed. New cloud-based accounting software makes it very easy to calculate and file the VAT returns both for VAT cash or accrual.
So while it is clear that accrual accounting needs more effort, technology will perform much of the heavy lifting for you. You should set up accounting apps to manage your bills and bring the numbers straight to the accounts on an accrual basis. Your invoices will also be recorded as profits when you collect them. So if you run a hybrid accounting system, smart software would help you to switch between cash basis or accrual basis anytime and anywhere you need to.
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