Should I use cash basis or traditional method of accounting?

If you are self-employed in the UK, you may wonder which accounting method is best for your business: cash basis or traditional (accrual) accounting. In this blog post, we will explain the differences between these two methods and help you decide which one suits your needs.

Cash basis of accounting

Cash basis accounting is a simple way to work out your income and expenses for your Self Assessment tax return. You only need to record money when it comes in and out of your business, and you only pay Income Tax on money received (after deducing expenses already paid) in your accounting period. This means you do not have to deal with invoices, bills, or debts that are not paid yet. For example, if you invoice a customer on March 25th 2023 and they pay you on April 18th 2023, you would record this income in the 2023/24 tax year, when you actually received the money. Cash basis accounting is suitable for small businesses with simple transactions. It also gives you a clear picture of your cash flow and how much tax you owe at the end of the year.

Cash basis accounting is suitable for most small businesses with a turnover of £150,000 or less per year. It can make your accounting easier and save you time and money (accounting and filing costs).

Note: If you have more than one business and decide to use cash basis, then you must use cash basisfor all your businesses. The combined turnover from your businesses must be less than £150,000.

However, there are some situations where cash basis may not be the best option for you, such as:

• You want to claim interest or bank charges of more than £500 as an expense.
• You run a complex business with high levels of stock or capital expenditure.
• You need to get finance for your business and a lender asks for accounts based on traditional accounting.
• You have losses that you want to offset against other taxable income (this can be a great advantage if you are likely to incur losses in the early years of your trade).

• You run a specific type of business that cannot use cash basis, such as a limited company, a Lloyd's underwriter, or a mineral extraction trade.

Note: If you use cash basis and your business grows during the tax year. You can stay in the scheme up to a total business turnover of £300,000 per year. Above that, you’ll need to use traditional accounting for your next tax return.

Traditional accrual accounting

Traditional accounting, also known as accruals basis, is based on invoices sent and received, regardless of whether payment has been made or not. Accrual basis accounting is a more complex but also more comprehensive method of recording your income and expenses when they are incurred, regardless of when money changes hands.You need to record income and expenses when you earn them or incur them, not when you receive or pay them. This means you may have to pay Income Tax on money you have not received yet. For example, if you invoice a customer on March 25th 2023 and they pay you on April 18th 2023, you would record this income in the 2022/23 tax year, when you earned it (even if money is not received yet).

Advantages of using accrual accounting

Using cash basis means you will likely save on accounting costs, as you don't need to use an accounting software or hire an accountant to do it for you. However, cash basis accounting has some limitations that may affect your business performance and growth. For instance, it does not show your outstanding debts or invoices, which means you may not have an accurate view of your profitability or financial position. It also does not allow you to claim tax relief on bad debts or offset losses against previous years or other income. Moreover, it may not be accepted by banks or investors if you need to raise finance for your business.

Accrual accounting has some benefits that may outweigh the additional costs. Besides showing your true profitability and financial position by matching your income and expenses to the period they relate to, it also allows you to claim tax relief on bad debts, offset losses against previous years or other income. Moreover, it is more widely accepted by banks and investors as it gives them a better understanding of your business operations and potential.

Pick the more tax-efficient method depending on your circumstances

The biggest difference would most likely depends on whether you have other types of income such as employment income, and whether your trade will likely make losses in the first few years . If the tax saved from potential loss reliefs outweigh the additional accounting costs, then accrual accounting may be right for you. If you are not sure whether cash basis accounting is right for you, you should talk to a tax professional before choosing your accounting method.

#KloudmancSmart #Tax #Self-employed