There are two main accounting systems to choose from; these are ‘cash basis’ accounting and ‘accruals’ accounting. Which of these methods you use will depend on the size and nature of your business, as they each have different advantages.
In general, cash accounting is best for ease, while accruals accounting is superior in terms of accuracy and understanding a business’ true financial position.
Keep in mind that choosing one accounting method does not necessarily mean that is the system you will always use.
As your business grows and changes, it pays to continually evaluate whether your current accounting system is still appropriate.
If the company is VAT registered, you should also give consideration to using the VAT cash accounting scheme.
Here, we discuss cash basis accounting to help you decide whether it fits your financial needs.
How cash basis differs to accrual
The difference between cash basis accounting and accrual accounting relates to the timing of when business income and expenditure are recorded.
Companies who use cash accounting log revenue and expenses as the money is paid out or received, while those who use accrual accounting record these transactions at the point an invoice is received or raised.
Which of the two systems you use for your company’s accounts will depend on a variety of factors, which we explore in this guide.
What is cash accounting?
Contrary to what the name suggests, cash accounting does not refer solely to transactions where physical cash changes hands; companies who make or receive payments electronically can also use cash basis accounting.
The cash accounting system dictates that purchases and payments are recorded only when a bill or invoice has been settled. This means, among other things, that any unpaid bills or invoices may not be included on your company tax return for that financial year. In contrast, businesses who use accrual accounting would include these figures, even if they have not yet received the money or paid the bill in question.
Besides simplicity, there are advantages and disadvantages to cash basis accounting, which are discussed later in this guide. In working out which system works better for your business, keep in mind that not all companies are eligible to use the cash accounting system.
What is the threshold for cash accounting?
Cash accounting is only available to companies with a turnover of £150,000 or less.
By delaying the tax liability until payment has been received, this method supports smaller businesses and sole traders experiencing delays between the time at which work is completed and the point payment for that work is received.
Who can use the cash basis?
To qualify for cash basis accounting, you must be an unincorporated partnership or self-employed individual, with a turnover of £150,000 or less.
Once eligible businesses exceed an income of £300,000, they must adopt the traditional accruals method of accounting for the following year’s tax return.
As the switch from cash accounting to accruals accounting can be jarring and potentially problematic when unplanned, it is essential to track the business’s income carefully and put measures in place to ease the transition from one system to the other, as you near the £300,000 exit threshold.
Commencing the first year using accruals accounting, companies should identify all debtors that must now be included on their tax return. Note that tax for these ‘opening debtors’ will be split across the first six financial years using the accruals system, to reduce the risk of cash flow problems for smaller businesses making the switch.
Is cash accounting right for your business?
Keep in mind just because you can opt to use cash accounting does not necessarily mean it is suitable for your business, so it is wise to consider both systems carefully.
Cash basis accounting can be advantageous for smaller businesses in industries where it is commonplace to experience a notable delay between raising an invoice and taking payment.
A good example of this would be independent solicitors who accept legal aid payments, as these can take well over a year to process. In this example, cash basis accounting would allow the solicitor to avoid paying tax on work that has been completed before they are paid for that work, eliminating potential cash flow issues.
Further to protecting businesses from paying tax on monies they have not yet received, cash basis accounting dramatically simplifies the tax calculation process for many companies and sole traders with straightforward operations. Such businesses may include window cleaners, mobile hairdressers, handymen and taxi drivers, who would likely benefit from only having to consider actual income and expenses, without factoring in payments owed.
Key considerations for businesses
If there is a chance that your business may engage in ‘barter’ style arrangements whereby payment is taken in the form of goods or services, note that these transactions must be recorded on your tax return at the fair market value at which those goods or services would usually be received or sold. For this reason, it pays to check the current market value before striking a deal.
While cash basis accounting relies on income being recorded only when it is received, note that this is the point at which the client or customer can reasonably be considered to have paid you. Any delay in money being made available that results from action (or inaction) on your part, does not mean you can disregard the payment. For instance, if payment is made via cheque but you do not immediately cash that cheque, the income should be recorded on the date the cheque itself changed hands.
Pros and cons of cash accounting
There are number of factors to consider when deciding whether the cash basis or accruals method is suitable for your business.
Cash basis accounting advantages
- Using cash basis accounting can give you an accurate and immediate snapshot of your company’s balances and available cash.
- Businesses who practice cash accounting benefit from the ability to claim ‘flat rate’ expenses for many common costs such as mileage and running a home office. This is generally much simpler, if not quite so tax-efficient, than tracking individual receipts and entering a detailed breakdown of expenses.
- Accounts preparation is far simpler to manage under the cash basis than accruals accounting as businesses will not have to make year-end accounting adjustments for debtors, creditors or stock. As such, it would be a good option for sole traders and small businesses with limited bookkeeping experience, or those who cannot afford an accountant.
- Companies that use cash accounting will not have to pay tax on income they have not yet received.
- Cash basis accounting often results in a smaller tax bill during the initial financial year, as partially completed work and debts owed to the business are not included in taxable profits for that period.
- Adjustments for capital allowances for plant and machinery are not necessary as capital expenditure (apart from cars) is relieved when incurred.
- Companies can move from cash to accrual as circumstances changes.
- Losses under the cash basis can be carried forward and set off against future profits.
Cash basis accounting disadvantages
- Moving between cash and accrual accounting gives rises to complications during the transition between systems.
- Reporting lower taxable profits to HMRC in the first year could interfere with the ability to obtain a bank loan or a personal mortgage.
- While cash accounting provides a clear picture of the cash you have on hand, this picture does not necessarily accurately reflect your financial position or business performance. Your accounts may portray the business as profitable, simply because you have not paid your bills. Accruals accounting would allow you a completely accurate view of your finances, if not the cash you currently have available.
- The deferral of tax is only temporary, as the timing differences on debtors, stock and creditors will unwind in the future. Transitional rules are in place to ensure that income and expenses will be allowed once, and once only.
Cash accounting offers smaller businesses a number of advantages but accrual accounting should also remain a consideration as it provides a more helpful basis to run a business with full insight and awareness of the business’ performance and financial position.
Remember that accounting mistakes can be seriously detrimental to your business and can result in financial losses, should inaccurate taxable profits be reported to HMRC.
If you are at all unsure about how to process with your company accounts, it is strongly recommended that you seek the advice of a qualified accountant. Doing so will help you to decide on the best way forward, whether that means managing your finances yourself or handing the responsibility over to an independent accountant or accountancy firm.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute tax, financial or legal advice, nor is it a complete or authoritative statement of the rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert tax, financial, legal or other advice should be sought.