What is cash accounting and does it help my business' cash flow?

Understanding your options on whether to use cash basis accounting or accrual basis accounting has an impact on your business’ cash flow and tax liabilities.

Cash basis versus accrual basis - what is the difference?

Cash basis is simply accounting for what cash comes in to the business in a reporting period minus cash out or expenses incurred during the reporting period. So if you don’t get paid for a job you have completed, you do not have to pay tax on it, as the income has not hit your bank account and you get automatic bad debt relief. This makes it a lot of simpler for many businesses and supports your cash flow. However, likewise, you cannot claim for expenses not yet paid for or incurred.

Compare this to accrual accounting, where you would still account for income that has been invoiced but not yet received by a client. Say you invoice for a piece of work on 1st April and your payment terms are 30 days from the issue date of the invoice and your year-end financial reporting period is 15th April, and your client pays you on the 25th April. In this example, you have issued an invoice in the year-end reporting period to 15th April and you will need to account for this as income and pay tax on it, even though you receive the income or cash in the bank in the following reporting period. This obviously damages your short term cash flow.

Another big difference is capital expenses. If you buy assets in your business that are eligible for tax relief, such as equipment in your business, under cash accounting, these will be recognised as an expense in the reporting period they are incurred or bought. Compared to accrual accounting, we hold capital expenditures on the business’ balance sheet and apply tax relief over a period of time against profits, so you still get tax relief, but sometimes this happens over a period of time or the lifeline of the capital asset versus the year of purchase.

Changes for sole traders and partnerships from April 2024

Currently, if you are a sole trader or operate a partnership and have a turnover of up to £150,000, you can ‘opt in’ to use cash basis accounting. However, from April 2024, this turnover threshold will be abolished, and the cash basis will be the default position for all self-employed people and partnerships. This was announced in the Autumn Budget 2023.

Furthermore, if you are currently using cash basis accounting, you can only enjoy up to £500 in interest tax relief in a given tax year and furthermore, any losses incurred in the business have restricted rules under cash basis accounting. When you make a loss in your business currently using cash basis accounting, you can only use losses against profits from the same trade, so if you have multiple revenue streams and you make a loss in one, but a profit in another, you cannot offset the losses against your profits from another trade.

In both cases - the interest tax relief threshold and the restrictions relating to losses - are being abolished as of April 2024, which will make the cash basis accounting method much more attractive for growing, unincorporated businesses.

To be clear, Limited Liability Partnerships, corporate partnerships, and limited companies are excluded from these changes.