Introduction to Cash Basis Accounting
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Cash basis accounting is a straightforward approach widely adopted by self-employed individuals and small businesses in the UK. This method only records income and expenses when they are paid or received, unlike traditional accounting or the accruals basis, which records income and expenses when they are incurred. The simplicity of cash basis accounting makes it a popular choice for sole traders and unincorporated businesses, especially for preparing their self-assessment tax returns.
Put simply, only money changing hands is recorded for tax purposes. All unpaid invoices and fees, whether creditors or debtors, are not submitted to HMRC until paid.
Autumn Statement 2023: Cash Basis Becomes Standard
As part of the Autumn Statement 2023, Chancellor Jeremy Hunt announced that Cash Basis will become the Accounting Standard for Self-Employed Taxpayers and Partnerships. Multiple restrictions have been lifted to open up Cash Basis accounting for businesses that did not previously qualify. This includes the £150,000 annual turnover disqualifying threshold and the maximum £500 interest deductible from taxable profits both being scrapped. These measures are now in line with the policies on the Accruals Basis.
This measure will take effect from April 2024, with the first accounting year being the 2024/25 tax year.
Key Measures of HMRC’s New Policy
- Businesses that use the cash basis can now deduct any amount of interest from their taxable profits as long as it is incurred wholly and exclusively for the purposes of the trade. Cash basis and Accruals Basis are now aligned on interest deductions.
- Cash basis losses work the same way as accruals basis losses. Cash basis losses can be set sideways against general income of the same period, or carried back to earlier years, subject to the same general loss relief rules as accruals losses.
- Businesses with any turnover whatsoever will use the cash basis of accounting, unless they elect to use the accruals basis.
- These measures only apply to self-employed taxpayers and partnerships, not limited companies.
- As a self-employed small business or partnership, you will have to elect to use the accruals basis. If you do not, you must use the cash basis.
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Key Features of Cash Basis Accounting
- Simplicity in Recording Transactions: Under cash basis, transactions are recorded only when cash changes hands. This means income is not recorded until received, and expenses are not accounted for until paid.
- Ineligibility for Limited Companies and Partnerships: Cash basis accounting is unavailable for limited companies and certain types of partnerships. These entities must adhere to the accruals basis or other generally accepted accounting principles.
Benefits of Using Cash Basis Accounting
- Ease of Management: Due to its simplicity, small businesses and self-employed individuals often find cash basis accounting easier to manage.
- Improved Cash Flow Visibility: It provides a clear picture of cash flow, as income and expenses are recorded only when they are physically paid or received.
- Reduced Complexity in Record Keeping: The record-keeping process is simpler without the need to track receivables or payables.
Limitations and Considerations
- No Recognition of Debts: Cash basis does not account for money owed or owing at the end of the tax year, which might not accurately reflect the financial position of a business.
Practical Application of Cash Basis Accounting for Self-Employed Individuals
Implementing Cash Basis in Business Operations
Cash basis accounting, while straightforward, requires a certain approach to ensure compliance and efficiency. Self-employed individuals and small businesses must adapt their record-keeping and financial management practices to use this method effectively.
- Recording Transactions: Keep diligent records of all cash transactions, including dates, amounts, and descriptions for both income and expenses. This ensures accurate reporting and helps during the self-assessment tax return process.
- Handling Invoices and Expenses: Record income when received, not when an invoice is issued. Similarly, expenses are recorded when paid, not when they are incurred.
Tax Considerations and HMRC Guidelines
- Self-Assessment Tax Return: When filing a self-assessment tax return, those using cash basis should report their income and expenses according to the actual cash flow of the business.
- VAT and Cash Basis: If registered for VAT, the business must account for VAT on the cash basis unless turnover exceeds the VAT threshold, in which case traditional accounting methods must be used.
- HMRC’s Rules and Thresholds: It is important to stay updated with HMRC’s rules regarding cash basis accounting, especially concerning turnover limits and eligible expenses.
Why Cash Basis? HMRC’s Reasoning
Conclusion and Key Takeaways
Cash basis accounting is an accessible and efficient method for many self-employed individuals and small businesses. It simplifies the accounting process, aligns well with tax return preparations, and provides a realistic view of cash flow. At Jack Ross, we recognise that major changes to the way in which you pay tax can cause anxiety. We are well-versed in adapting to HMRC’s constant changes to policy and are happy to advise on any tax queries you may have, whether it is for yourself or your business.
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By electing to use the cash basis, self-employed individuals can simplify their self-assessment process. This method requires you to record income only when it is received and expenses when they are paid. This simplifies the accounting process as it does not require you to track accounts payable or receivable, which could make your tax return easier to prepare.
Yes, you can still claim allowances while using cash basis method but not capital allowances, with the exception of cars. Instead, you can claim for purchase of items as expenses in most cases.
In traditional accounting, income and expenses are recognised when they are invoiced, not when the cash changes hands. However, in cash accounting, income and expenditure are recognised only when payment is received or made. This can lead to a more accurate reflection of cash flow.