Cash or Accruals Basis – Which One is Right for your Business?

Cash or Accruals Basis – Which One is Right for your Business?

If you’re a small business one of the most important accounting decisions you can make is whether to choose the cash or accruals basis to prepare your accounts.

What is the difference between cash and accruals basis accounting?

The accruals basis (sometimes referred to as traditional accounting) is perhaps the most well-known. Under the accruals basis, income is recorded when it is earned, and expenses are recorded when they are incurred. In practice, this typically means that your business’ income and expenses are reported according to the date you issued an invoice (for income) or were billed for something (for expenses).

The cash basis, on the other hand, is a much simpler basis on which to prepare your accounts. This is because, in essence, all the business needs to do is report cash as it comes in and as it is paid out. Note that cash doesn’t just refer to physical pounds, pennies, and banknotes, but refers to all payment methods (including bank card, cheque, and payment in kind).

Are there any other differences?

One significant difference between the cash and accruals basis is that of timing. Under the accruals basis, a business may end up reporting income before they have actually received any corresponding cash payment. From a tax perspective, this may mean that you have to report and pay tax on income that, had the cash basis been used, would not have been taxable until the following tax year.

To use a well-worn example (bearing in mind that the UK tax year runs from 6 April to the following 5 April):

  • You send an invoice to a client for £1,000 on 1 April 2019, but you don’t receive payment from that client until 10 April 2019.
  • If you used the accruals basis of accounting, that £1,000 should be reported in your 2018/19 tax return, the self-assessment filing and payment deadline for which is 31 January 2020.
  • If using the cash basis, that £1,000 is reported in the 2019/20 tax year, the self-assessment tax return for which is not due until 31 January 2021 – a year’s difference.

Another difference between the cash basis and traditional accounting is that the cash basis carries some restrictions that it’s worth being aware of. For example, there is a cap on how much relief can be claimed in respect of loan interest and incidental costs of obtaining loan finance (such as bank fees) with a maximum deduction of £500 permitted.

When can you use the cash basis?

The cash basis aims to make life simpler for small businesses that may struggle with traditional accounting. As such, it is available for use by self-employed business structures (think a sole trader or a partnership where all partners are individuals). In the UK, limited companies and limited liability partnerships cannot use the cash basis.

There is also a turnover limit for when the cash basis can be used - specifically, a business should have a turnover of £150,000 or less a year. Where an individual has more than one business, the combined turnover from all businesses should not exceed £150,000 if the cash basis is to be used. Note that once on the cash basis, a business can keep using the cash basis until turnover exceeds £300,000 per year. Once the £300,000 threshold is passed, the business should move to the accruals basis of accounting.

If your business qualifies for the cash basis and you wish to use it, simply tick the cash basis box when preparing your self-assessment tax return.

Is the cash basis compulsory?

In short, no. If your business meets the criteria to use the cash basis, you can choose whether you’d prefer to use the cash or accruals basis.

It’s also worth noting that it is possible for an existing business to switch from the accruals basis to the cash basis. However, as some adjustments may be needed to your accounts if you go down this route, it’s best to speak to an accountant or tax adviser for further guidance.

When can you use the accruals basis?

Essentially, if the cash basis isn’t available to your business (for example, because your business is structured as a limited company) or you don’t want to use the cash basis, you should use the accruals basis of accounting.

How do I know which basis is right for me?

If you are eligible to use either the cash or accruals basis, there are a few pros and cons to weigh up.

Cash basis

While the cash basis is much simpler than traditional accounting, it may not be right for your business if you’re anticipating fast growth, as you’ll quickly exceed the upper threshold to stay within the scheme.

Additionally, some businesses may have a commercial reason why the cash basis may not be suitable (perhaps because they have significant amounts of bank charges or interest that they would like to claim, the nature of their business is inherently complex, or the business relies on external financing, as some banks may ask to see accounts prepared under the traditional basis).

Accruals Basis

The accruals basis does not always reflect your business’ cash position, as there can be a timing difference (as noted above) between when cash is reported versus when it is received. As a result, it’s very important that businesses that use traditional accounting also prepare cash flow statements and keep on top of their cash flow position more generally. It’s very easy for a business that reports using traditional accounting to look highly profitable on paper, only for it to transpire that the business has no cash to continue as a going concern.

Don’t be afraid to get help

If your business has the option to choose between the cash and accruals basis, it may be worthwhile speaking to a chartered accountant to get their advice on which basis would be most suitable for your business, based on your business’ own unique requirements and set of circumstances.