The above headline appeared in an article in The Times recently. There is something fundamentally incorrect in what it says, which I detail below. Let me say first that I am bashing the article author or the paper, as most papers do such things when covering firm performance.
So what is wrong with above statement? Simply, it is the application of the accruals concept in accounting. Under this concept, revenues and expenses are matched, and when cash is received/paid is not relevant – at least in the calculation of profit.
Here is a simple example. Let’s assume a business sells goods for $1,000 cash but has not paid the supplier. The goods cost $600. The profit on this is $400. If the supplier is never paid, or is paid in 10 days, the profit will not change.
While the article is incorrect in terms of the title, it’s message is solid – that you can benefit by not paying people. In the simple example above, the business has $1000 in the bank.
In Ireland and the United Kingdom (and maybe come other countries) it has always been possible for smaller business to pay VAT based on cash received rather than on an accruals basis. You probably know what the accruals concept is, but if not click here. When I teach accounting or prepare accounts, the accruals concept is used almost without exception. The profit & loss account (income statement) and balance sheet (statement of financial position) will definitely use the accruals concept. In fact, these financial statement often take a different name and format when prepared for a cash-based business. For example, when I teach how to prepare the financial statement of not-for-profit organisations such as clubs, we often refer to a “Receipts and Payments Account” and a “Statement of Affairs”. The former is like an income statement, but is based on cash records; the latter is a list of assets and liabilities and will normally draw on the accruals concept.
From April 1st 2013, the UK tax authorities permits smaller unincorporated businesses to use a cash based accounting scheme where the turnover is less than £77,000 (see here for more detail). I’m not a UK tax expert, but from my reading about the topic on the web, the “income” of a small business will be the cash received, and the “expenses” will be cash paid for business expenses. This sounds like a reasonable effort to simplify the tax system for the smallest of businesses. The accruals concept may not be that relevant to many of these businesses as, for example, they may have few assets (to depreciate) and receive payment for most work as soon as it is done. So all fine? Well apparently, many accountants protested this new scheme, and that’s not surprising given how the accruals concept is engrained not only in the teaching of accounting, but also in accounting regulations. As a management accountant, I would always encourage the smallest of businesses to think in cash terms – it is easier for business owners with little accounting skills to understand. But I do see one big problem with this scheme in the UK. It centres around what happens when turnover exceeds £77,000. Once this happens, the business must revert to accruals accounting. This would cause much confusion if a business is using accounting software. Normally, accounting software incorporates accruals accounting, but some also support cash accounting in the way described here. I’m not 100% sure, but I would imagine if you set up software to work in one method, it may not be that easy to switch. So even though this cash scheme is easier and optional for small UK business, if they use accounting software (and more and more do) then it is probably best to stick to accruals accounting.