What is Cash Accounting?

What is Cash Accounting?

Cash accounting is an accounting method whereby payment receipts are recorded during the period in which they are received, and expenses are recorded in the period in which they are actually paid.

Cash accounting is also called cash-basis accounting and may be contrasted with accrual accounting, whereby revenue or expenses are recorded when a transaction occurs rather than when payment is received or made. 

Who can use cash accounting?

In the UK, cash accounting is an option for those who run a small self-employed business, such as a sole trader or partnership, and have a turnover of £150,000 or less a year.

If you have more than one business, then cash basis accounting must be used for all businesses and the combined turnover must be less than £150,000.

If the decision is made to use cash accounting and a business grows during the tax year, it is possible to stay in the scheme up to a total business turnover of £300,000 per year. Above that, it becomes necessary to move to accrual accounting for the next tax return.

Limited companies and limited liability partnerships can’t use cash accounting. In addition, specific types of businesses, such as waste disposal, dealers in securities and ministers of religion, are unable to use the scheme. A full list of exemptions is available on the UK government website.

Benefits of cash accounting

Cash accounting is simple and straightforward to learn, implement and maintain, with transactions recorded only when money goes in or out of an account. As it involves cash accounts, it also removes the complexity of additional accounts such as accounts receivable and payable, or any long-term liability accounts. 

It’s also useful for seeing exactly how much cash a business has available as it deals only in concrete funds rather than having to factor in future income and expenses.

Limitations of cash accounting 

There are, however, a number of drawbacks when it comes to cash accounting, the main one being that it may not provide an accurate and complete picture of your financial situation, particularly when it comes to a business’ liabilities. This could lead to the impression that you have more finance available than is actually the case or – if you’re awaiting payment for a large job which involved a significant outlay, for example – that your financial state is worse than it actually is. Both of these situations could have a negative impact on decision making if the full financial picture isn’t clear.

There are also potential tax consequences for businesses that opt for cash accounting. As businesses can generally only deduct expenses that are recognised within the current tax year, if a company incurs expenses in late March 2020, but does not make payments against the expenses until the end of April, it would not be able to claim a deduction until the next tax year. This could potentially affect a business' bottom line. Likewise, a company that receives payment from a client in 2021 for services rendered in 2020 will only be allowed to include the revenue in its financial statements for 2021.

It should also be noted that it can be tricky to switch from cash to accrual accounting, which may be necessary as a company grows. To do so will involve adjusting the discrepancies between the timing of cash payments/receipts and the actual exchange of goods or services, which can be a complex process.

Example of cash accounting 

So, how does cash accounting work in the real world? Take the example of a company that received £50,000 on the 5th of June for sales to a customer made a month earlier. Under the cash accounting method that sale would be recorded as taking place on 5 June when payment was received, regardless of the fact that the order was placed in May. Under accrual accounting, however, the sale would have been recorded on 5 May, even though the goods hadn’t yet been paid for.

Expenses will be handled in a similar way. So, if a new piece of machinery is ordered in January but not paid for until February, the expense would not be recognised until February via the cash accounting method. For those operating under accrual accounting, it would be recorded on the books when the purchase was agreed.

Cash accounting can be a quick and easy way for start-ups to begin managing their finances, but in the longer-term it’s unlikely to be conducive to the financial planning and understanding that will be needed to encourage business growth. Whilst it may be simpler for small businesses, waiting too long to switch to accrual accounting can add to the complexity, making this a costly and time-consuming process, so think carefully when starting out before deciding which method is right for you.

VAT Cash Accounting Scheme

Some companies that are registered for VAT may also be eligible to use the VAT Cash Accounting Scheme, which should not be confused with the cash accounting method for your financial statements.

Using the VAT Cash accounting scheme means that businesses can account for VAT on sales on the basis of payments received, rather than on tax invoices issued. This is different to traditional accrual accounting whereby they would be required to account for VAT on sales when a VAT invoice is issued, even if has not been paid. Similarly, it is only possible to reclaim the VAT incurred on purchases once a supplier has been paid.

The VAT Cash Accounting Scheme could be particularly useful for those businesses that offer customers extended credit or that suffer a lot of bad debts. It is, however, less beneficial for those who regularly reclaim more VAT than they pay, who make continuous supplies of services, or who are usually paid as soon as they make a sale.

To be eligible, companies must have an estimated VAT taxable turnover of £1.35 million or less in the next 12 months and must not use the Flat Rate VAT scheme. They also must not have any outstanding amounts owing to HMRC or have been convicted of a VAT offence within the past year.