Cash Basis vs. Traditional Accounting

cash-basis-vs-traditional-accounting

We’ve all felt it – that biting breeze which rolls in once a year and chills us to the bone.

The words ‘Self-Assessment Filing’ don’t have to raise goose-bumps, however. Staying on top of our finances throughout the year can help us beat those annual tax blues. 

Most of us want a simple, hassle-free system to keep track of our financials and get us through the self-assessment season in one piece.

How you balance the books is largely up to you – as long as you operate in the parameters of HMRC’s approved accounting systems.

These systems are cash basis accounting and traditional (also called ‘accrual’) accounting. 

Understanding which one works best for you will give you a major confidence boost once that self-assessment deadline rolls around. Not only that – it’ll also give you a clearer picture of where your business is at and where it’s headed. 

Here’s an overview of each system to help you break it down. 

CASH BASIS ACCOUNTING

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If your business has an annual turnover of £150,000 or less, this is probably the system for you. 

With cash basis accounting, you’ll only record income and expenses that have actually gone through. For example, if you’ve invoiced a client and their payment is still outstanding, you won’t need to declare it.

This means it won’t count towards your overall profit margin – resulting in you paying less income tax.

To clarify: you WILL still need to pay tax on that income. As with all dues owed to HMRC, it’s a question of ‘when’ not ‘if’. The only ‘if’ here is whether that invoice actually gets paid. 

Once it’s paid, you will have to declare it. However, if it was paid after the 5th of April, it would be added on to next year’s self-assessment. 

Here’s how it works:

  • You invoice a client on March 30th, 2020 (tax year 2019/2020)
  • The Client pays the invoice on April 10th, 2020 (tax year 2020/2021)
  • This income wouldn’t be included in your 2019/2020 self-assessment. Instead it would be rolled over to 2020/2021

The value in cash basis accounting lies in the fact that you don’t pay tax on income you haven’t yet received.

If your business is just starting out, this method gives a much wider margin for error while you fine-tune the details.

Not everyone is able to access this type of accounting. Limited companies and limited liability partnerships, for example, can’t use Cash Basis.

Here is a (very niche) list of other businesses unable to use this model:

  • Lloyd’s underwriters
  • farming businesses with a current herd basis election
  • farming and creative businesses with a section 221 ITTOIA profit averaging election
  • businesses that have claimed business premises renovation allowance
  • businesses that carry on a mineral extraction trade
  • businesses that have claimed research and development allowance
  • dealers in securities
  • relief for mineral royalties
  • lease premiums
  • ministers of religion
  • pool betting duty
  • intermediaries treated as making employment payments
  • managed service companies
  • waste disposal
  • cemeteries and crematoria

We said it was niche. 

TOP TIP:

You can continue using cash basis accounting until your business reaches a turnover of £300,000 per year (provided you don’t fall into one of the above categories, that is).

TRADITIONAL ACCOUNTING

traditional-accounting-small-business

Also known as accrual accounting, this method requires its users to record every invoice that you send or receive – regardless of whether it’s been paid.

You’ll also need to file the income under whichever tax year it was created, even if it’s honoured after the April deadline. 

For example:

  • You invoice a client on March 30th, 2020 (tax year 2019/2020)
  • The Client pays the invoice on April 10th, 2020 (tax year 2020/2021)
  • This income would still need to be filed under your 2019/2020 Self Assessment

Paying tax on income you haven’t actually received yet (or at all) might seem unfair. However, for businesses turning over an excess of £300,000 a year, combing through bank statements to determine the status of each and every invoice simply isn’t practical. Also, the VAT would be a nightmare (as if it isn’t already)!

The good news is that you can use any unpaid invoices to offset future losses.

With traditional accounting, you can carry the previous year’s losses over to the next tax year. Doing this lowers your reported profit margin – meaning you pay less tax as a result. 

TOP TIP: 

If you’re a sole trader turning over £150,000+ a year, consider setting up a limited company. Doing this will boost your eligibility for a wider range of schemes and better rates. 

SIMPLIFIED EXPENSES

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This isn’t an exclusive third system. However, if you’re a Cash Basis user working from home for 25+ hours a week, or travel for business, you might want to take advantage of this scheme. 

Simplified Expenses lets sole traders and self-employed users file certain expenses at set flat rates. These flat rates can only be used for the following:

  • Business costs for vehicles
  • Working from home
  • Living in your business premises

To work out which flat rate you should claim, you’ll need to keep an annual log of:

  • Your business miles for vehicles
  • Hours you work at home
  • How many people live in your business premises 

At the end of the tax year, you can use HMRC’s flat rates to work out your expenses and add them to your final claim.

Here’s an example:

Hours of business use per monthFlat rate per month
25 to 50£10
51 to 100£18
101 and more£26

Suppose you worked 30 hours from home for 10 months, but November and December were swamped and you put in 70 hours both months. The first 10 months fall under the flat rate of £10, while the final 2 months come in at £18. You can claim £136 for the year.

Simple. 

TOP TIP: 

Self-employed sole traders can claim the first £1,000 of income as a flat tax-free allowance.

Doing this means you won’t be able to claim any other expenses. For most self-employed traders, though, this amount is usually less than their actual business expenses.

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WANT SOME HELP WITH THAT?

If you’re self-employed, a sole trader and have a low to medium profit line, cash basis accounting is your best bet.

For limited companies, however, traditional (accrual) accounting is usually the way to go.

Still not sure which system is the best fit for your business? Get in touch and let us walk you through it!

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