Cash based accounting / record keeping is an allowance to make it easier for small businesses to maintain their business accounts. It is aimed at sole traders and partnerships.
If your turnover is less than £150,000 per annum then you can use a cash based form of accounting for your business (If you have multiple businesses then they must be totalled in aggregate). Note: If you are using a Limited Liability company or Limited Liability partnership, then you cannot use cash based accounting, irrespective of turnover.
What are the advantages of a cash based form of accounting?
Easy to understand and apply by someone with very limited financial knowledge.
Simplicity saves time and effort related to record keeping. It can be as simple as every transaction that appears in your bank statement from the start of your accounting year through to the last day. (Assuming every transaction is put through a single bank account).
Generally, results in a deferral of tax liability. Close to the end of the financial period if you’re paying for materials/expenses before receiving payment from customers then you’ll invariably have income falling into a future tax year while the expenditure attached will fall into this year. Another example is a business that buys stock for resale, under a cash basis you will claim as an expense upon payment which will generate a tax benefit, with the tax liability only being generated once the stock is sold.
Matches and tracks cashflow which focuses attention on it.
You can add a small increase in complexity if you wish through using the date of any cheques written or received to be included in your accounts so long as you are consistent with the basis year to year.
A small business can easily maintain its financial records through a reconciled cashbook which can be electronic (Say as a spreadsheet in excel) or even manually on paper (As they used to be done).
In the United Kingdom if your turnover is greater than (2022 £85,000) then you will be required to register for VAT (Value added Tax). Under a cash based accounting process then you can elect to simply show all income and expenditure at their cash amounts, however you will need to show any payment or receipt of VAT (To/from HMRC) as expenditure/income.
What are the disadvantages of cash based accounting?
The major disadvantage is one of accuracy and matching of revenue and expenses. Two basic examples being:
If for instance in a previous year there was a delay in receiving a payment from a customer then it could mean it slips into a following years income (Based on when the cash is received) which then would entail a larger tax payment as the income would be taxable this year with the cost claimed in the previous year.
Conversely if you buy items for the business on account and sell them prior to year end but end up paying the supplier after year end, then you pay artificially more tax this year (On profits) and then less next year when the costs would be recorded.
One specific limitation of cash based accounting is that for HMRC purposes you can only claim a maximum of £500 for interest and bank fees cost.
If you operate a very cash based business with limited Debtors / Creditors or financing, then the disadvantages should be minimal, furthermore you are free to use accrual based accounting if a cash based approach is not beneficial.
However, as HMRC now requires all VAT registered business to file electronically their VAT returns, it almost necessitates accounting software reducing the benefits of cash based accounting. Hence, cash based accounting benefits are increasing contained to businesses not registered for VAT.
Note: ‘Some’ financial writers state that banks require accruals based accounts to be prepared. I do not believe this to be the case (I never encountered it), they are generally more interested in the reliability of the accounts prepared I.e. Did an accountant prepare them? and do your accounts match the tax returns they invariably will ask for, as part of the credit check / verification process.
What are the advantages of an Accrual based accounting approach?
Effectively income and expenses are more appropriately matched which ensure greater accuracy with respect to profits and therefore greater accuracy with respect to tax payable for the business year.
What are the disadvantages to an Accrual based accounting approach?
Cost to maintain the record keeping and finalisation of profits. In effect your accounts will reflect all the cash transactions and accruals (adjustments) to ensure correct matching of income and expenditures. As examples if you sell on credit (or have debts owing at year end for partial work undertaken) then you will need to have Debtors recorded and the income attached, likewise things like supplies/stock purchased but not paid for at year end will need to recorded as Creditors.
Given a greater level of detail and knowledge will need to be applied to the accounting records it is likely to require the use of an accountant and/or accounting software. Effectively increased compliance costs.
If you run a small business with a turnover less than £85,000 then a cash based accounting process may be ideal on a compliance cost basis. Once over £85,000 you will be required to register for VAT and file returns electronically, this may well necessitate the use of electronic accounting software and the use of a Bookkeeper/Accountant thus negating most cost compliance benefits of cash based accounting.
Finally, once you surpass £150,000 of turnover you must use accruals based accounting. However, you can use cash based accounting for the year in which you surpass it, unless you exceed £300,000 in that year, which will require accruals accounting for the full year.