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Whether you take the lead on your financial reporting or leave this in the hands of an accountant, it’s important to know how your income and expenses are accounted for.
There are two ways of doing this: cash accounting and accrual accounting. The main difference lies in timing, and the method you use can affect which transactions count towards your annual business turnover and even how much Income Tax you need to pay.
This blog explores how each accounting method works and how to decide which method is right for you.
What is cash accounting?
Cash accounting records transactions when money changes hands. This means that income is accounted for on the date you get paid and expenses are accounted for on the date money leaves your business.
What is traditional accounting?
Also known as accrual accounting, traditional accounting records income and expenses when a sale or purchase is agreed to – regardless of when money changes hands.
Examples of cash accounting vs traditional accounting
You order a new laptop worth £1,000. You place the order on 9 October but don’t have to pay until the laptop is delivered on 20 October.
Under cash accounting, the £1,000 expense is reported on 20 October – the date the money leaves your business. If you use traditional accounting, you should report the expense on October 9 – the date the order was placed.
You work as a freelancer and have accepted a job for £500. You invoice the customer on 30 March 2022, giving them 30 days to pay. The customer pays on 10 April 2022.
If you use cash accounting, you should report the £500 income on 10 April – the date you received the payment. If you follow the principles of traditional accounting, the income is reported on 30 March – the day you sent the invoice.
As the UK tax year runs from April 6 to April 5 the following year, the income could be attributed to different tax years, depending on which accounting method you use.
Who can use cash accounting and accrual accounting?
Any business can use traditional accrual accounting, but you can only use cash accounting if:
- You have an annual turnover of £150,000 or less
- You’re a sole trader or run a partnership.
There's also a few specific businesses that must use traditional instead of cash accounting – including Lloyd’s underwriters, management service companies and certain types of farmers.
Accounting methods for multiple businesses
If you run more than one business, you must use the same accounting method for all your businesses. And you can only use cash accounting if your businesses have a combined turnover of £150,000 or less.
Which accounting method is right for me?
If you’re able to choose between cash and traditional accounting, it’s important to weigh up the pros and cons of each approach.
It’s always a good idea to speak to an accountant about important financial decisions, but some of the key factors to consider include:
Cash accounting only requires you to report money that’s changed hands, so it’s quite simple to pick up if you have no previous experience in finance or bookkeeping.
By comparison, traditional accrual accounting is slightly more complicated. You need to keep track of accounts payable (short-term obligations owed to your creditors or suppliers) and accounts receivable (money you’re waiting to be paid), as well as money that's coming in and out of your business. This may seem daunting, but the right accounting software can make things easier.
Accuracy and insight
Cash accounting can provide a clear snapshot of your cash flow, so you can see exactly how much money you have to hand at any given moment. However, it can’t give a clear picture of your business’ overall financial health as it doesn’t consider accounts payable or receivable.
The opposite is true of traditional accounting – while it provides a more accurate picture of your finances, it can obscure the view of your cash flow. This issue can be tackled by producing regular cash flow statements, but this involves more work.
If you use cash accounting, you don’t pay Income Tax on money you’re waiting to be paid or invoices that never get paid at all. If you use traditional accrual accounting, all sales within a given time frame count towards that period's taxable turnover – and this means you could end up paying Income Tax on money you haven’t actually received.
At first glance, cash accounting may therefore seem like the best option. But this isn’t always the case.
Firstly, many businesses require payment up front – so accounting methods don’t affect when income is recorded and therefore have very little impact on your tax bill.
Secondly, allowable expenses can reduce your Income Tax bill – but only if you can claim them. If you use cash accounting, you may not be able to claim some of your purchases until you've actually paid.
Cash accounting is generally considered the easier, more straight-forward option for small businesses. But if you’re likely to change company structure or hit the £150,000 turnover threshold, you’ll have no choice but to switch over to accrual accounting.
Some small businesses therefore use traditional accounting from day one, so they’re familiar with the process and don’t need to adjust to a new accounting method.
Investors and banks typically need to know what you owe and how much you're owed before they’ll agree to a loan or funding. For this reason, they’ll often ask to see accounts drawn up using traditional accrual accounting.
If your business is likely to seek financial support, you may want to consider using traditional accounting so you can provide all the necessary information and don’t create any roadblocks further down the line.
VAT Cash Accounting Scheme
The VAT Cash Accounting Scheme is a way of reporting and paying VAT that follows the principles of cash accounting. Businesses using the scheme pay VAT on sales when they’re paid by their customers and reclaim VAT on their purchases when they pay their suppliers.
In order to use the scheme, your business’ estimated VAT taxable turnover must be £1.35 million or less.
Like cash accounting for Income Tax, the VAT Cash Accounting Scheme has pros and cons. It’s worth speaking to an accountant or tax advisor if you’re not sure whether the scheme is right for you.
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This content has been created for general information purposes and should not be taken as formal advice. Read our full disclaimer.
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