Cash Accounting – should I tick the box?
Each year many self-employed people complete their tax return and have absolutely no idea whether they are, or should be, using the cash basis of accounting! Here we compare traditional accounting with cash accounting so that you can make the right decision on what is best for you.
Who is eligible
You can use cash basis if you:
- run a small self-employed business, for example sole trader or partnership and
- have a turnover of £150,000 or less a year
If you have more than one business, and choose to use the cash basis you must use it for all your businesses. The combined turnover from your businesses must be less than £150,000.
The cash basis is not an option for a company.
Traditional accounting v cash accounting
Traditional accounting works on the accrual’s basis, which basically means you record sales at the time you make the sale, rather than when you receive the cash, and expenses when you incur the expense, rather than when you pay the cash.
Imagine a gardener who does a large landscaping job in December. His year end is 31 December 2018. The customer does not pay him for the work until January. Using traditional accounting the sale would be included in his year end 31 December 2018 and will, therefore, be included in his 18/19 tax return.
Cash accounting records sales and expenses on the date that the cash is received or paid. Our gardener above would include the sale from the work in December in January 2019 when he receives the cash. It will, therefore, be in the year end 31 December 19, part of his 19/20 tax return.
So, for a trader who has a delay in receiving cash from customers, cash accounting can have cash flow benefits in delaying when tax is paid on a sale.
Of course, if you have a business that always receives cash up front but delays paying for supplies, the cash accounting system could result in a cash flow disadvantage.
The traditional accruals basis can provide more relevant information if you are a business with high levels of inventory as it ensures that the cost of inventory is allocated to the same period as the sale of the goods. Cash accounting can lead to distorted profit figures in that situation.
One of the biggest advantages of the cash basis is that it gives automatic tax relief for bad debts. If a customer doesn’t pay, you never receive the cash, never include it in your accounts and, therefore never pay tax on the income.
With traditional accounting, the sale would be recorded, and bad debt relief can only be claimed once the cash is more than 6 months overdue and has been written off in the accounts. This will often mean that the tax will be paid on the sale in one tax year and tax relief cannot be claimed until a later year……. again, bad for cash flow.
Under traditional accounting, you separate your expenses into revenue expenses and capital expenses. Revenue expenses are deducted from our income to get our profit, whereas capital items are potentially eligible for capital allowances (a bit like depreciation but using tax rules).
Under the cash accounting basis, you don’t worry whether expenses are capital or revenue, they can all just be deducted from income at the time the cash is paid.
Cash accounting is, therefore, a little bit easier but given the existence of the annual investment allowance, capital allowances are normally 100% in the year of acquiring capital assets, therefore the overall tax position is similar.
HMRC do not allow capital costs of cars to be treated as an expense, therefore regardless of whether you are using traditional or cash accounting, the treatment of cars is the same, you can either choose to claim capital allowances (at either 100%, 18% or 8% depending on the CO2 emissions of your car) or you can choose to claim a mileage allowance under the simplified expenses scheme.
Under the cash basis, the maximum deduction that can be made for interest and bank charges in any year is £500. If your business has significant debt such that charges and interest are more than this, this may mean the cash basis is not for you.
Under traditional accounting, there are several options for claiming tax relief should you make losses:
- offset the loss against your general income in the tax year of the loss – this allows the loss from your business to offset against things like employment income, rental income, dividends and interest, resulting in an income tax saving.
- Offset your loss against general income in the previous tax year – again saving income tax and with the benefit of being able to claim a tax refund for previously paid tax.
- If you are in your first 4 years of trade, carry your loss back against general income in the 3 years prior to the year of the loss. This can be very useful if perhaps you have been employed on a large salary historically and have now decided to start your own business. Losses are common in the first year as you incur all your set up and marketing costs and take time to build your customer base. Setting the losses against your 3 years previous high earnings can result in tax refunds, which is great for cashflow.
- Carry the loss forward against future profits from the trade.
Under the cash basis, the only loss option is to carry the loss forward, thus relief for losses will not happen until your business starts to make profits.
If you have losses, or expect to make losses, please come and chat to us…..it is quite a complex tax area with some important opportunities for tax planning.
So, should you tick the cash basis box?
Cash basis is administratively easy and can have timing benefits for tax purposes.
However, it is probably not for you if you expect to have a lot of interest or bank charges, you are expecting to make losses and have had high levels of income in the current/previous years or you are likely to need to raise finance as banks will often require traditional accounting.