Launching a business means making many decisions including understanding the difference between cash basis and traditional accounting. It’s essential to get an understanding of which method is best for you and your business.
No matter what you think, the most important point to remember is your business needs to keep financial records. Without adequate records, you cannot prepare self-assessment or corporate tax returns for HMRC. So, what is the difference and what do you need to know?
Cash basis and traditional accounting
Cash basis accounting is a simpler version of accounting for small businesses and the self-employed. The general idea is that your income and expenditure are included in your accounts records ONLY when something is paid or received.
This means that any unpaid or outstanding invoices are not included in your year-end tax return. Similarly, you can’t include any expenditure until it is paid in full by you.
This example explains how it works:
You issue an invoice on March 18th 2024 but your client doesn’t pay you until April 23rd 2024. In traditional accounting, this invoice would be included in your accounts and you would pay tax on the amount invoiced. But if you use cash basis accounting, then that payment won’t be included until the following financial year. As a result, you won’t pay tax on that amount until the following financial year.
Who can use cash basis accounting?
You can use cash basis accounting to work out your income and expenses until your total business turnover exceeds £300,000 per annum. Once you reach this threshold, you must use traditional accounting. You can use cash basis accounting if you:
- Run a small business and are self-employed
- Are a sole trader or partner
There are businesses that cannot use cash basis accounting. These are:
- Limited companies and limited liability partnerships (LLP)
- Any businesses that work in mineral extraction
- Businesses that have claimed a business premises renovation allowance
- A business that claims R&D tax relief
The government has a full list of businesses that cannot use cash basis accounting.
Can I use cash basis accounting if I’m VAT registered?
As long as your income is below £150,000, you can use cash basis accounting if you’re registered for VAT. If you choose to use this method, you must record all VAT payments made to HMRC as expenses. And if you receive any VAT repayments from HMRC you should record them as income. Once it exceeds £150,000, you will need to use traditional accounting.
What is traditional accounting?
Traditional accounting is also known as accrual or accrual basis accounting. This means every invoice sent or received is recorded in your financial accounts whether they’ve been paid or not.
As we mentioned in our earlier example, if you sent an invoice on March 18th 2024, you will pay income tax even if it’s not paid until April 23rd! If you’re VAT registered, you can offset any losses with traditional accounting, something you cannot if you’re using cash basis accounting. It is usually beneficial for VAT registered businesses to use traditional accounting.
Who can use traditional accounting?
Any business, self-employed person or partnership can use traditional accounting. Larger businesses use this form of accounting – but smaller businesses can use this method, too.
You will need to keep standard business records, which includes:
- Income owed but not yet received
- What you are committed to spending but haven’t paid yet – for example, purchase invoices
- Year-end bank balances
- The value of stock at the end of your accounting period
- How much you have invested in the business in the financial year
- What monies you have taken from the business for personal use
Cash basis and traditional accounting: what’s best?
In most cases, when it comes to accountancy, it all depends on your individual circumstances. If you would like advice about cash basis and traditional accounting and what is best for your business, contact our friendly team today.
