What is Cash Basis Accounting?
Keeping tabs on your business’s finances can seem complicated, but it doesn’t have to be. Cash basis accounting is a straightforward method that’s perfect for small businesses and those just starting out. It’s like balancing your chequebook – you record income when you receive it and expenses incurred.
Think of it this way: if you sold a product today and got paid right away, you’d record that sale today. But if you sent an invoice and haven’t been paid yet, you wouldn’t record it until the money actually arrives in your account.
In this blog post, we’ll break down how cash basis accounting works, its benefits for small businesses, and some things to watch out for. We’ll also help you decide if it’s the right method to keep your finances organised and your business running smoothly.
Who Uses Cash Basis Accounting?
Introduced by HM Revenue & Customs (HMRC) in the fiscal year 2013-2014, the cash basis accounting method significantly simplified the process for small businesses to manage and complete their financial accounts. This approach allows small enterprises to focus on their core operations without being overwhelmed by complex accounting requirements.
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. You must use accrual accounting if you reach this turnover the following year.
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.
If you are self-employed, when completing the self-assessment tax returns, you will find an option to select the cash basis accounting method.
As a limited company, you are required to adopt the accrual accounting method, as the cash basis is not permitted.
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 and easy to understand, even for those without a background in accounting. You simply 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.
Reflects Actual Cash Position: It more accurately reflects the actual cash position of your business, 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, there are several downsides.
- 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.
- 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 a 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-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 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 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.
| Cash Method | Accruals Method | |
|---|---|---|
| Income | 1000.00 | 5000.00 |
| Cost of Sales | 500.00 | |
| Gross Profit | 500.00 | 5000.00 |
| Expenses | ||
| Sub-Contractor | 250 | 300 |
| Net Profit | 250 | 4700 |
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.
Using the two different methods for tax purposes 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.
The turnover must be less than £150,000 for your combined self-employed businesses to use the cash basis.
