There are two accounting methods; cash basis accounting and accruals accounting.
This section will look at cash accounting, its advantages, and who can use it and compare it to the accrual method.
The cash accounting system records revenue and expenses when received and paid.
Who Uses Cash Basis Accounting?
The cash basis was introduced by HMRC in 2013-2014, making it more straightforward for small businesses to complete their accounts.
You can only use the cash basis if you have a turnover of less than £150,000; it includes all of your businesses. once you use the method, you can continue to use it until your annual turnover is greater than £300,000. If you reach this turnover the following year, you must use accrual accounting.
Many self-employed, freelancers and small business ventures use cash basis accounting as it is easy to use, and they understand it better. Using the cash basis is very similar to keeping track of personal finances.
To see if you can use the cash basis accounting, further information is available on the Government website.
When completing the self-assessment for the tax year, there is a box to tick for the cash basis.
If you are a limited company, you can’t use the cash basis and must use the accrual method.
When a transaction is recorded as revenue in the bank account, it is entered as revenue in the accounts on the date the bank transaction took place. It is the same for payments.
The cash basis method does not keep track of accounts receivable and accounts payable; it is therefore not suitable for most small businesses offering or receiving credit.
One of the significant advantages of using the cash basis is that you will only pay tax at year-end when the revenue is received or spent.
Advantages of Cash Basis Accounting
Here are the advantages of using the cash basis:
- Easier to set up and use.
- Only pay tax on income and expenses when money is received or spent.
- It may work out cheaper if you can do it yourself.
Disadvantages of Cash Basis Accounting
Although using the cash basis is easier to record, there are several downsides.
- If you apply for a business loan or overdraft, you may need accruals accounting.
- 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.
- 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 the business turnover is £1.35 million or less, you can join the scheme, and you are VAT registered.
The main advantage of using the cash accounting scheme is that you pay HMRC the VAT when paid and not when an invoice is issued.
A business can use accrual accounting or cash basis for the financial reports and use 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 a customer on 30 days payment terms. The customer pays the following month. The transaction is in the accounts when the invoice is issued to the customer.
Read more on the 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.
|Cash Method||Accrual Method|
|Income Recorded when cash received||Income recorded when the transaction takes place|
|Expenses recorded when the cash spent Expenses posted when they are billed or stock used.||Expenses are posted when they are billed or stock used.|
|Taxes are only paid on money received||Taxes due on transactions that have taken place (may not have been paid)|
|Used by freelancers and Self-employed||Used by small businesses and limited companies|
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 months 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.
|Cash Method||Accruals Method|
|Cost of Sales||500.00|
As you can see from this example, the net profit shows a very different figure for the same transactions in the financial statements.
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.
For tax purposes, using the two different methods impacts the amount of tax you may pay.
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 to use, 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.
To use the cash basis, the turnover must be less than £150,000 for your combined self-employed businesses.