What is Cash Basis Accounting?

Managing your business finances can seem daunting, but it doesn’t have to be. Cash-basis accounting is a straightforward method that is perfect for a sole trader, partnership, or freelancer. It’s similar to balancing your chequebook—you record income when received and expenses when paid.

For instance, if you sell a product today and receive payment immediately, you record the sale today. However, if you send an invoice and haven’t been paid yet, you won’t record it until the payment is deposited into your account.

This article will explore cash-basis accounting, outlining its benefits for small businesses and highlighting potential drawbacks. We’ll also help you determine if it’s the right method for organising your finances and ensuring smooth business operations.

Who Uses Cash Basis Accounting?

Introduced by Her Majesty’s Revenue and Customs (HMRC) in the fiscal year 2013-2014, cash-basis accounting simplifies financial management for small businesses. This approach allows them to concentrate on core operations without burdening them with complex accounting requirements.

You can use the cash basis if your turnover is less than £150,000 across all your businesses. Once you adopt this method, you can continue using it until your annual turnover exceeds £300,000. If your turnover reaches this threshold, you must switch to accrual accounting the following year.

Many self-employed freelancers and landlords prefer cash-basis accounting due to its simplicity and user-friendly nature. It closely resembles personal finance tracking.

To see if you’re eligible for cash-basis accounting, visit the UK Government website for further details.

If you are self-employed, you will find an option to select the cash-basis accounting method when completing the self-assessment tax returns. From April 2024, the cash basis is the default option, and you must opt out to use the traditional accounting method.

Limited companies are generally required to use the accrual-basis accounting method. The cash basis is typically not permitted for these types of businesses due to regulatory requirements and the need for more comprehensive financial reporting.

Cash Basis Changes from 2024 – 2025 Tax Year

From the 2024-25 tax year, sole traders and partners will automatically use cash-basis accounting for their Self-assessment tax returns. This means you’ll record income when received and expenses when paid. However, you can choose to opt-out and use traditional accounting if you prefer. Some businesses may not be eligible for cash-basis accounting and must use traditional accounting.

Several changes have been made to the cash-basis system:

• Turnover thresholds have been eliminated.
• The limit on interest deductions of £500 has been removed.
• Losses can now be offset against other taxable income.
• If you have multiple businesses, you can choose different accounting methods for each.

To opt out of cash-basis accounting and use traditional accounting, tick the appropriate box on your Self-assessment tax return. If you need assistance, consult a tax professional or accountant.

Cash Accounting Method Definition

Cash basis accounting is a method of recording your business’s income and expenses based on when money actually changes hands. This means you record income when you receive payment and expenses when you pay them, regardless of when the transaction occurred.

Advantages of Cash Basis Accounting

Here are the advantages of using the cash basis:

Simplicity: This is the most significant advantage. Cash basis accounting is straightforward to understand, even for those without a background in accounting. You record income when received and expenses when paid.

Easy Tracking of Cash Flow: Since transactions are recorded when cash changes hands, it provides a clear picture of your business’s cash flow. This helps you monitor your liquidity and make informed financial decisions.

Reduced Bookkeeping Costs: Due to its simplicity, cash basis accounting often requires less time and effort to maintain, which can lower bookkeeping costs.

Tax Benefits (in some cases): Depending on tax regulations, the cash basis may offer tax advantages, such as deferring taxes on income not yet received. Your taxable income is based on the money you have received and spent.

Reflects Actual Cash Position: It more accurately reflects your businesses actual cash position, which is a crucial factor for many small businesses concerned about meeting immediate financial obligations.

Disadvantages of Cash Basis Accounting

Although using the cash basis is easier to record, several downsides exist.

• You may need accruals accounting if you apply for a business loan or overdraft.
• It doesn’t show income when invoiced; therefore, the profit or loss might be misleading.
• If the business purchases stock or inventory, it is recorded when paid for rather than when used.
• It is harder to make business decisions without complete information.

Free Excel Cash Book

If you want to set up your accounts on a cash basis, you can download our free cash book in Excel.

It allows you to enter all the income and expenses from the bank statements, check the correct bank balance, and view the year’s profit and loss.

Cash Accounting for VAT Returns

HMRC has a cash accounting scheme for VAT. If your business turnover is £1.35 million or less, you can join the scheme, and you will be VAT registered.

The main advantage of using the cash accounting scheme is that you pay HMRC the VAT when you pay it, not when an invoice is issued.

A business can prepare financial reports using accrual accounting or a cash basis and the VAT cash scheme.

Accrual Basis Accounting

Accrual basis accounting gives a more accurate picture of the income and expenses of the business. It shows the transaction when it takes place rather than when it shows in the bank.

At the end of the tax year, the business must ensure that any accrual adjustments are taken into account before the final accounts are produced.

An example of the accrual method is a business invoice to a customer on 30-day payment terms. The customer pays the following month. The transaction is in the accounts when the invoice is issued to the customer.

Read more about accrual basis in accounting with more examples.

Difference Between Cash Basis and Accrual Accounting

The key difference between cash and accrual accounting is the timing of when the transaction is recorded in the accounts. The accrual method posts the transactions when they occur and the cash basis when the cash is received or spent.

The main difference is shown in the financial statements when comparing the two accounting methods.

Below is a table showing the difference between cash and accrual basis.

Accrual Accounting vs Cash Basis Accounting Example

The easiest way to understand the differences is to look at some examples. We will use a self-employed business that offers computer consultancy and uses sub-contractors for the additional workload.

The financial transactions for the month are as follows:

Receives £1000.00 from a previous month’s invoice.

Issues an invoice for £5000.00, which remains unpaid at the month-end.

Purchases a computer for £500 for a client, which will be invoiced the following month.

Pays a subcontractor £250 relating to last month.

Receives a subcontractor invoice for £300.

Below are the income statements for the two different methods.

As you can see from this example, the net profit figure for the same transactions in the financial statements is very different.

The accruals method will post the invoice of £5000.00 to the accounts receivables. And the £500 to accounts payable. Both of these general ledger codes are part of the balance sheet.

Using the two different methods for tax purposes impacts the amount of tax you may pay.

How to Change from Cash Basis to Accrual Basis Accounting

Transitioning from a cash basis to accruals basis involves adjusting how you record income and expenses. Here’s a breakdown of the process:

1. Identify Transition Date: Choose a specific date to begin using accrual accounting. This is usually the start of a new fiscal year, tax year or accounting period.
2. Account for Unpaid Invoices: Record any unpaid invoices as accounts receivable. These represent income earned but not yet received.
3. Account for Unpaid Bills: Record any outstanding bills as accounts payable. These represent expenses incurred but not yet paid.
4. Adjust Inventory: If your business deals with inventory, record the value of unsold inventory as an asset on your balance sheet.
5. Depreciate Fixed Assets: Start depreciating fixed assets (like equipment) over their useful life, rather than expensing them immediately.
6. Software and Expertise: Consider using accounting software to facilitate the transition. You might also need to consult with an accountant or bookkeeper for guidance.
7. Reconcile Accounts: Regularly reconcile your accounts to ensure that your financial records are accurate and up-to-date.
8. Inform HMRC: If you’re registered for VAT, inform HMRC of the change in your accounting method.

Challenges and Benefits of Transitioning

• Challenges: The transition can be time-consuming and may require adjustments to your accounting systems. You might also need to learn new accounting principles.
• Benefits: Accrual accounting provides a more accurate picture of your business’s financial performance. It can also make securing financing and making informed business decisions easier.

If you’re considering transitioning from cash-basis to accrual accounting, carefully weigh the challenges and benefits to determine if it’s the right decision for your business.

Making Tax Digital

HMRC are introducing making tax digital for Income Tax Self-Assessment (ITSA) from April 2024. It means that the self-assessment tax return will be submitted using third-party software.

Although Excel templates might be easy and cheap, you might need to look into accounting software in the future.

Cash Basis Accounting Summary

The Cash method of accounting is the most straightforward accounting system to implement and maintain. A simple spreadsheet might be enough to keep track of the accounts.

The turnover must be less than £150,000 for your combined self-employed businesses to use the cash basis.