Female business owner in red jumper and glasses on laptop

Traditional accounting vs. cash basis: Which is better for your business?

August 3, 2022
When launching a new business, you’ll need to be prepared to make a lot of big business decisions early on in your entrepreneurial career. For instance, when registering as self-employed with HM Revenue and Customs (HMRC), you’ll need to decide whether to use cash-basis or traditional accounting.Depending on the nature of your business, you might find you’re only eligible for one or the other, but for those in the middle you might be looking for some expert advice.Before catching up with an accountant, you might want to have a baseline understanding of your options and what they entail before making your final decision.If so, read on — we’ll be covering both cash basis and traditional accounting in depth, what each method entails and the eligibility criteria for each.

What is traditional accounting?

While this does mean you have to pay Income Tax on cash you haven’t yet received, this can be particularly beneficial for larger, VAT registered businesses. Not only does traditional accounting makes it a lot easier for businesses to deal with VAT, but you can also offset any losses using this approach.

What records do I need to keep under traditional accounting?

On top of the standard business records you’ll need to keep as a business owner, traditional accounting requires you to have records of the following:

    Income you’re owed but haven’t yet receivedWhat you’ve committed to spend but haven’t yet paid (e.g. purchase invoices)Your stock value at the end of your accounting periodYour year-end bank balancesHow much you’ve invested into your business in the yearThe total amount you’ve taken from the business for personal use

Who can use traditional accounting?

Any business can use traditional accounting, although this approach is generally better suited to larger businesses who have stock and larger assets.This doesn’t mean, however, that smaller businesses can’t adopt this approach — you might even find it beneficial if you’re expecting rapid growth early on.

What is cash basis accounting?

Cash basis accounting is the simpler approach of the two, and involves recording income and expenses as the money either enters or leaves your bank account.This means that if you have any unpaid or outstanding invoices at the end of the tax year, you won’t need to list them on your tax return until the next year, when you have (presumably) been paid.
As a result, you won’t have to pay tax on income you haven’t received yet, meaning you won’t end up paying more tax than you have to in the case a client refuses to pay.

However, there are a few cases where items are treated differently where cash basis is less beneficial than traditional accounting. Cash basis might not be right for your business if:
    You want to claim interest or bank charges of more than £500 as an expense Run a business that handles high levels of stock Your need to get finance for your business — some banks may want to see accounts drawn up using traditional accounting, so that they can see what you owe and are due before agreeing to give you a loan Want to offset any losses you’ve made against other taxable income, known as ‘sideways loss relief’ Want to claim capital allowances — you can’t claim capital allowances on any business expense except cars, with items purchased for you to use and keep in your business classified as allowable expenses under cash accounting

Who can use cash basis accounting?

You can use cash basis accounting if you:
    Are self-employed and run a small businessAre a sole trader or partnerHave a turnover of £150,000 or less a year
While this is the eligibility criteria to start using cash basis accounting, you can continue to use this method of accounting to work out your income and expenses until your total business turnover exceeds £300,000 per year. Once you’ve surpassed this threshold, you’ll need to use the traditional accounting method for your next tax return.It’s also worth highlighting the businesses that can’t use the cash basis accounting scheme:
    Limited companies and limited liability partnershipsBusinesses that have claimed business premises renovation allowanceBusinesses that carry on a mineral extraction tradeBusinesses that have claimed research and development allowances
You can find the full list of businesses that aren’t eligible to use the scheme at GOV.UK.

Can I use cash basis if I’m VAT registered?

If you’re VAT registered, you can use cash basis accounting to work out your business income and expenses, as long as your income is below £150,000.
Whether you’re voluntarily registered or have surpassed the £85,000 VAT registration threshold, you can record income and expenses either with or without VAT. However, it’s crucial that income and expenses are recorded in the same way as not to distort the figures on your tax return.

If you do choose to include VAT, you’ll need to record:
    VAT payments made to HMRC as expensesVAT repayments received from HMRC as income

Simplified expenses

Since the cost of some items aren’t always obvious, HMRC has introduced simplified expenses as a way of making tax less taxing.Simplified expenses enable business owners to calculate some of their business expenses using flat rates. This option is only available to those using the cash basis method.Flat rates can be applied to the following items:
    Mileage allowance from using your car Working from home expenses Costs from living at your business premises (running a guest house, bed and breakfast or small care home)
For more on how to work out and how much you can claim in simplified expenses, you can check out our guide to simplified expenses.

Join us in creating the new age of accounting.

Simple language, simple software, so that you can spend less time dealing with admin and more time focusing on what really matters.