If you’re a self-employed business owner, you will need to choose a type of accounting you prefer when registering with HMRC: cash basis or traditional.
In this guide, we’ll be explaining what the differences are and how to decide which is best for you and your business.
What is Cash Basis Accounting?
Businesses that use cash accounting only recognise income and expenses once money has changed hands. Sent invoices aren’t counted as income, nor are bills considered expenses until they have been settled.
Despite the name, cash basis doesn’t actually have anything to do with the form of payment you receive. You can be paid with cash or electronically and still do cash accounting.
What are the Benefits of Cash Basis Accounting?
Cash accounting is a simpler option for calculating tax. It shows exactly how much money you have on hand at any given time.
What are the Downsides of Cash Basis Accounting?
- It isn’t accurate – you could be under the impression that you are more profitable than you really are, just because you haven’t paid your bills.
- It isn’t useful when you want to make management decisions, as you only have a day-to-day view of your finances.
Examples of Cash Basis Accounting
Example 1
Jane runs a small bakery. She invoices a local cafe £500 for baked goods delivered in June. Under cash basis accounting, Jane will only recognise this £500 income when the cafe pays her in July.
Example 2:
Tom, a freelance graphic designer, receives a bill for his website hosting services in May but pays it in June. Tom will record this expense in June when he actually pays the bill.
Changes to Cash Basis Accounting in 2024
Last year [2023], the government ran a consultation on the current income tax cash basis rules to find out how they could be expanded and simplified. Prior to the new 2024/25 tax year, over two-thirds of eligible businesses didn’t use the cash basis method – despite the benefits it has to offer.
Five key changes came following the findings of the consultation. They are as follows:
Cash Basis is Made Default
The cash basis is the default method of calculating taxable profits. Traditionally, the default accounting method has always been accrual, however, from now on businesses will need to opt out of the cash basis default on their tax return if they wish to continue using the accrual method.
The Turnover Threshold is Removed
Previously, businesses needed a turnover of less £150,000 or less in order to use cash basis accounting. However, this has now been removed.
The £500 limit on Interest Deduction When Using Cash Basis is Removed
This aligns cash basis with accrual accounting, where there are no limits on interest deductions.
Restrictions on Using Relief for Losses Under Cash Basis are Removed
This aligns cash basis with accrual accounting, where there are no restrictions on using relief for losses.
You Can Now Use Cash Basis or Traditional Accounting for Each of Your Businesses
Previously, if you owned multiple businesses, you had to choose one method of accounting for all of them. If their combined turnover was more than £150,000, you were required to use accrual accounting for them all.
Now, you can choose accrual, cash basis or hybrid for each of your businesses individually, with no thresholds in place.
What is Accrual or ‘Traditional’ Accounting?
Businesses that use accrual accounting recognise income as soon as an invoice is raised, and recognise an expense as soon a bill comes in – even if it won’t be paid for another 30 days.
What are the Benefits of Accrual Accounting?
- You gain a more accurate picture of your business’ finances and how it is performing.
- You are able to make more informed financial decisions.
- Accrual accounting makes it easier to pitch for long-term finance.
What are the Downsides to Accrual Accounting?
- Accrual accounting requires more attention, as you have to watch your invoices, not just your bank account.
- You may need to pay tax on income prior to payment from the customer. But don’t worry – if the customer doesn’t pay the invoice, you can claim the tax back on your next return.
Hybrid Accounting Methods
Some businesses may opt for a hybrid accounting system. Thai is where they typically base big financial decisions and things such as loan applications on accrual accounting, but use cash-basis accounting to simplify their tax reporting.
It’s worth noting that there are lots of rules around which businesses can and cannot do this. Speak to our team at Ryans to determine what type of accounting your business is eligible for.
Which Accounting Method is Best for My Business? Cash vs Accrual vs Hybrid Accounting?
If you’re uncertain of which type of accounting is best for your business, you should consider the following:
Accrual accounting gives you a greater indication of business performance because it shows when income and expenses occurred. If you’re looking to see if a particular month was profitable, accrual will tell you.
It’s rare to use cash accounting on its own, but some businesses like to use cash basis accounting for certain tax purposes and to keep tabs on their cash flow.
Although accrual accounting requires more work, with advanced accounting software, technology can take most of the administrative burden for you. Your accounting software can read your bills and enter the numbers straight into your expenses on an accrual basis.
Hybrid accounting systems allow you to switch between cash basis and accrual basis whenever you need.
Cash Basis Accounting FAQs
What’s the difference between cash basis and accrual accounting?
The difference between cash basis and accrual or traditional accounting is the timing of your revenue and expense recording. If you record them when you pay or receive money, it’s called cash basis accounting. If you record your revenue and expenses after getting a bill or raising an invoice, this is known as accrual accounting.
Can I switch from cash basis to accrual accounting (or vice versa)?
Yes, you can switch from cash basis to accrual accounting or vice versa. However, you should consider the implications and consult with an accountant before making the switch, as it may affect your tax reporting and financial statements.
Are there any restrictions on using cash basis accounting?
No. From April 2024, the restrictions on cash basis accounting have been removed.
How does cash basis accounting affect my tax return?
Under cash basis accounting, you only pay tax on the income you’ve actually received and deduct expenses you’ve actually paid. This can simplify tax reporting for small businesses and potentially improve cash flow management.
Can I use cash basis accounting if I have employees?
Yes, you can use cash basis accounting if you have employees. However, you must still comply with payroll and other regulatory requirements.
What are some common pitfalls of cash basis accounting?
Common pitfalls include:
- Misleading financial health: Delays in income or expense recognition can give a skewed view of profitability.
- Cash flow issues: Failing to recognise outstanding bills may lead to unexpected cash flow problems.
- Limited suitability: Not ideal for businesses with complex financial transactions or those requiring detailed financial analysis.
How can I decide which accounting method is right for my business?
To decide which accounting method is right for your business, consider:
- Business size and complexity
- Nature of transactions (e.g., frequent invoices or inventory management)
- Financial reporting needs
- Tax implications
- Long-term business goals
Consulting with an accountant can help you make an informed decision.
Can I use different accounting methods for my different businesses?
Yes! Previously, HMRC required consistency in the accounting method used across your entire business. However, from April 2024 onwards, you can choose different methods of accounting across all of your businesses.
Can I use different accounting methods for different parts of my business?
Some businesses may use a hybrid approach for internal purposes while maintaining a consistent method for tax reporting. It’s best to seek professional advice to ensure compliance.
What accounting software is recommended for cash basis accounting?
Several accounting software options are suitable for cash basis accounting, including:
- QuickBooks
- Xero
- Sage
Does cash basis accounting affect my ability to get a loan?
Cash basis accounting may affect your ability to secure long-term financing, as lenders typically prefer accrual accounting for its comprehensive view of financial health. However, maintaining accurate and detailed records can help mitigate this issue.