What is best for my business? Cash accounting or accrual accounting basis?
In accounting there are two methods of managing your finances:
- Cash accounting
- Accrual accounting
Accounting on a Cash Basis is where you record your transactions when the “cash” or funds actually “change hands”, so the income (revenue) is recognized when you receive payment and expenses are recognised when they are paid.
Accruals accounting is where you record your transactions when the service or delivery of a product is completed and invoiced, whether payment has been received or not.
Small (and not so small) businesses are now able to use the Cash accounting method, but it is important to understand the advantages and disadvantages for your particular business.
Advantages of cash accounting
- Easy to understand and simpler as businesses do not have to make year-end accounting adjustments for debtors, creditors or stock.
- Matches the actual cash flow
- No need to make adjustments for capital allowances for plant and machinery, as capital expenditure (apart from cars) will be claimed as a normal expense when paid for.
- At the end of the tax year, businesses will not have to pay tax on income earned, but not yet received.
- The scheme is flexible and can be moved to the accruals basis if the business circumstances change sufficiently
- Single entry system is more simple, but does have its drawbacks.
Disadvantages of cash accounting
- Single entry system means that errors are less likely to be picked up.
- Short term indicator: As it does not show any income that has been invoiced and not received or expenses that are still payable, it can give a significantly misleading view of your true financial position.
- In order to be offered credit or to secure loans, banks might require accounts to be prepared on an accruals basis.
- If the business has a car and it chooses not to adopt the simplified expenses mileage rate method, capital allowances adjustments will still need to completed.
- The deferral of tax is only temporary, as it is only a timing difference and the tax will need to be paid eventually.
- Can only claim interest or bank charges of not more than £500 in total for a year.
- Cannot offset losses against other taxable income.
You can only use Cash Basis accounting if you:
- Run a small self-employed business or partnership i.e not a limited company
- Have an income of £150,000 or less.
If you have more than one business, you must use the Cash Basis for all, and the combined turnover of your businesses must not exceed £150,000.
You can stay in the Cash accounting method until your business reaches an income of £300,000 per year. Over that you will need to use the accruals accounting method.
Who can’t use the Cash Basis?
- Limited companies and LLPs
- Specific types of businesses listed on the HMRC website.
Cash Basis accounting is is primarily designed for small businesses with relatively modest debtors, creditors or stock, but to ensure you make the most cost-effective decision when choose your accounting method, contact us for a free consultation.