Adrian pearson is A VETERAN UK CHARTERED ACCOUNTANT AND the founder of ledgerscope - A SOFTWARE COMPANY MAking great tools for accountants in practice.

Cash accounting is common sense accounting

An article in the August 2012 edition of Economia magazine considers whether small businesses will benefit from the proposals to allow them to prepare accounts on a cash basis. As someone who has worked closely for over 25 years with businesses that will qualify to use cash accounting, I disagree with many of the points made.

Clive Lewis (ICAEW's head of enterprise) suggests that cash accounting takes small businesses away from the basic structure of the profit and loss account, stating:

You lose the need for figures such as turnover, gross margin, operating expenses and net profit.

No you don't. These figures will still be reported; just on a money in and out basis, rather than on an invoices in and out basis.

Richard Churchill (partner with firm Shelley Stock Hutter) agrees with Clive and argues that bad decisions may be the result of cash accounting. He says:

You can't get a true picture by looking at what is going in and out of the bank.

For the vast majority of businesses this is true but nobody is suggesting that, simply because they report only on a cash basis, business owners will suddenly disregard all of the other numbers that they already use to understand how they are performing.

Business owners know if they are making a profit, or running into cash flow problems even if they don't prepare management accounts. They are adept at mentally working out what the money in the bank plus the money they are owed, less what they owe out comes to. And they know that if this number is higher than last time they did the mental sum, they are making a surplus.

Likewise, every client I have ever worked with knows that if the calculated number at the end of the year is the same as it was at the start, but the stock room is three times as full, they have made a surplus.

Business owners also intuitively understand that the money they are owed is made up of unpaid invoices plus the value of work done not yet invoiced. They understand that what they owe is not just the unpaid invoices they have received but also purchases they have not yet got the paperwork for. So that's work in progress valuation and accruals covered. 

Further, since for many established businesses the opening and closing debtors, creditors and stock remain at fairly consistent levels from period to period, the bank balance can actually be a pretty good indicator of their profitability.

Clients don't need full accrual accounting lessons to know how they are doing, they just use their own financial common-sense. We should understand this and stop patronising them.

The most astonishing comment in the article comes from Anita Monteith (ICAEW technical manager for SME tax) who believes that businesses with growth potential might allow cash accounting to limit their ambition, suggesting:

Once you apply a distinction people trade up to that level and not beyond.

What? Really? I cannot think of any client I have worked with who would turn away the chance to make more profit simply because they would then have to get their accounts done in a different format.

Yes, it is well-known that some small business owners would deliberately ensure that their profits fall just below the VAT registration threshold, rather than just above it. But that's a different situation entirely; VAT registration can reduce net profitability for many businesses dealing with the general public. But deliberately reducing profits to make a small saving in accountancy admin? I don't think so.

In summary, I don't think the Economia article makes any contribution to the cash accounting debate. For me it unfortunately reinforces my feeling that the officers of the ICAEW are out of touch with what's happening on the ground, in real small businesses in the real world. And the concerns raised by accountants in practice about cash accounting are merely poorly disguised protectionism.

Is Sage gaining or losing market share?

Accountants getting the software bug