Most unincorporated businesses have now fallen into the cash basis method for calculating their profit and loss rather than the traditional accruals basis.
The change took effect on 6 April 2024, so the cash basis becomes the default method for the 2024/2025 tax year.
Pros and cons
Accruals
The accruals basis is more complex, but provides more comprehensive information to run a business.
With the accruals basis, income and expenditure are matched to the period in which they are earned and incurred, rather than when they are received or paid.
Your invoices may not be paid for some time after they’re raised: but your credit sales are included in your income tax computation regardless of whether or not customers have paid for the goods or services by the end of the accounting period. Likewise, you may not pay the bills you receive for 30 days after you receive them, but you get the tax relief straightaway.
In due course, your tax liability is based on this complex mixture of debtors and creditors. In terms of management information, the larger the business, the more important up to date financial information and control will be. This is where the accruals basis comes into its own. By recognising income when it’s earned and expenditure when it’s incurred, the accruals basis gives a business a real-time picture of how it’s performing. This is likely to be necessary in any case where a business applies for finance or grant funding.
Cash basis
Cash basis is simpler. It just tracks cash movement. Businesses are taxed on the basis of receipts, less allowable payments made during the basis period. Receipts are recognised as income of the period in which received, and expenses are outgoings of the period in which they’re paid.
All money received by the business is taxed when received. This includes proceeds from the sale of any plant and machinery, as well as trading income. Credit sales are accounted for and taxed in the year that the customer pays.
To be eligible for deduction, expenses must be paid in the accounting period: and be incurred wholly and exclusively for the purposes of the trade. Interest costs under the cash basis are generally deductible.
The costs of most plant and machinery can be included as deductions from trading profits. Car purchase is the main exception, and relief for this comes via capital allowances. Particularly significant, however, is the fact that cash basis involves complex adjustments for capital assets — such as vans, for example — with both business and private use; and this can impact tax bills.
If non-business use of such assets goes up materially, it falls to be treated as a sale of part of the asset at current market value.
HMRC example: Hugo buys a van for his business. Initially, private use is 10%. Hugo’s wife later starts to use the van for weekly supermarket trips, and private use increases to 30%. An amount based on market value at the time of the change has to be taken into account as a cash basis receipt as a result. This will impact Hugo’s tax bill.
Using cash basis takes out a raft of adjustments that would otherwise be needed, such as debtors, creditors, stock and work-in-progress adjustments. It means the business can — in theory — keep simpler accounting records.
But it is important to bear in mind that this doesn’t provide the same solidity for management purposes. Knowing what your stock levels are and having a clear picture of debtors and creditors — these are big tools for business control, and you may not want to do without them — even if you are eligible to use cash basis.
Further reading
Topical Issue: Using cash basis accounting publication.
Cash basis accounting who is affected?
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