Accounting is the process of logging the income and expenditure of a business and working out how much tax it must pay based on its net profits. Once the total expenditure has been taken away from the total income, the business is left with the profit margins on which it must pay tax.
Any business or self-employed worker must use either cash-basis or traditional (accrual-basis) accounting. Cash-basis follows direct cash transactions, whereas traditional accounting tracks all revenue even if it is credited and the cash has yet to be transferred.
But what is the difference between cash-basis and traditional accounting? How do both methods work? Is one better than the other? And can any business opt to use either method?
We are going to take a look at the two methods of accounting as we find out the difference between cash basis and traditional accounting.
Cash-basis accounting only includes income and expenses that have already been paid for and are only for smaller businesses that have a turnover of £150,000 per year or less. Traditional accounting takes credit transactions into account and is the mandatory method for businesses that have a turnover of more than £150,000 per year.
Both methods have their advantages and disadvantages. Cash-basis is simpler but is only available to smaller businesses with limited turnover. Traditional accounting is slightly more complex but it is more widely accepted by various accounting bodies.
So let's jump in and take a closer look at the details of both methods.
Accounting is used by self-employed people and businesses to keep track of how much money is coming in and how much is going out. If you subtract the expenses of a business from its income you get the net profits. This is then what the business pays tax on.
Most people pay their Income Tax through their wages on the PAYE system. However, self-employed people and businesses, have to keep a record of their transactions and pay tax on their profits.
Many businesses opt to employ an accountant to complete all of the company's taxes and finances. On the other hand, self-employed people often update their own tax affairs by completing a Self Assessment tax return annually. There are also many self-employed people who also use accountants for their taxes. Of course, an accountant costs money to employ, whereas completing your own tax returns is entirely free.
Cash-basis accounting is an accounting method that has been used in the UK since the 2013/2014 tax year. It was brought in to make accounting simpler for smaller businesses and for self-employed people.
Unlike traditional accounting, with cash-basis accounting, a business records its revenue only when customer payments have been received and when any company expenses have been paid to suppliers. The company's taxes are then calculated on the total net income in a given tax year.
Cash-basis accounting does not account for either customer sales or company purchases that are made on credit. Instead, it simply follows the real cash flow to provide a full overview of the company's cash status.
This means that it is much easier to keep on top of the amount of money a business has at any time as they can simply check their accounts for the transactions that have been made and completed.
Cash-basis accounting can only be used by small businesses and self-employed people. You can use cash-basis accounting if you:
- run a small business or are self-employed
- have a turnover of £150,000 or less a year
If you run more than one business then you must use cash-basis accounting for all of them. You can only use cash-basis accounting if the combined turnover from all of your businesses is less than £150,000.
Smaller businesses often find that cash-basis accounting suits them better than traditional accounting.
If you use cash-basis accounting and your business then grows over the course of the tax year, you can continue to use cash-basis up to a turnover of £300,000. Anything above that needs to be processed through traditional accounting.
You can use cash-basis accounting if you are VAT registered as long as your income is £150,000 or less during the tax year.
If you do use cash-basis accounting, you can choose to record your business income and expenses either excluding or including VAT. However, you must treat income and expenses the same way. So if one includes VAT, so must the other and vice versa.
If you choose to include VAT you must record:
- VAT payments you make to HMRC as expenses
- VAT repayments you receive from HMRC as income.
As with all accounting, it is vital that you keep financial records of all your business's income and expenses so that you can work out your net profits for your annual tax return.
Income
If you are using cash-basis accounting, you only need to record income that you have actually received within the tax year.
This means that anything you are owed but did not receive before April 5th that year is not included. Any payments made after April 5th then roll over to the next tax year.
Expenses
Expenses are any costs that are paid to maintain the functioning of your business. You can deduct business expenses from your income to work out your profit. This then also determines how much Income Tax you will pay.
With cash-basis accounting, you must only include expenses you have already paid for. Any credited expenses do not count until the payment has been made.
Traditional accounting, or accrual accounting, is a form of accounting that records a business's income and expenses when it invoices customers or receives a bill.
With traditional accounting, all credit payments are included for both business income and expenses, even if they haven't been made within the tax year.
Traditional accounting is used by bigger businesses and self-employed people that have a turnover that is greater than £150,000 per year.
If you or your business turnover more than £150,000 per year, then you need to use traditional accounting.
If you use traditional accounting you need to include all income and expenses records that belong to a specific tax year. Include all invoices that have been issued and received even if they have yet to be paid.
If you make a payment that covers more than one tax year, then you need to spread the costs over the period they belong to. For example, if you pay a whole year's rent in advance halfway through the tax year, then only include half of the payment in that year's accounts and include the other half in the next year's.
There are strict rules on what can and can't be claimed by businesses and self-employed people as business expenses.
Generally, allowable expenses do not include money taken from your business to pay for private purchases.
You can usually claim business expenses on:
- office costs, this might include stationery, internet fees, and phone bills
- travel costs, this might include petrol, parking fees, or train, plane or bus fares
- clothing costs, this might include uniforms or safety clothing
- staff costs, this might include subcontractor costs
- things you buy to sell on, this might include stock or raw materials
- financial costs, this might include insurance fees or bank loan interest charges
- costs of your business premises, this might include heating, lighting, gas, and business rates
- advertising and marketing, this might include website costs, dissemination fees, or billboard space
- training courses related to your business, this might include health and safety courses or refresher courses.
Capital Allowance is money you can get deducted from making purchases that are going to be used in your business for a long time. Capital Allowance varies depending on what you bought, but it can be as much as an 18% reduction.
Amongst other things, capital can include:
- equipment
- machinery
- business vehicles, for example, cars, vans, and lorries.
If you use traditional accounting, you can also claim Capital Allowances when you buy capital for your business.
If you use cash-basis accounting, you can only claim Capital Allowance on cars. All other items must be claimed as allowable expenses in the normal way.
Cash-basis accounting is the simpler of the two methods and is good for small businesses and self-employed people, though this does mean that it is limited to only certain businesses.
However, cash-basis accounting can sometimes lead to a business falling into a trap of thinking that it is cash-rich. This is because it doesn't record future expenses that might exceed the cash on the books.
Traditional accounting is more complicated as it requires keeping a tab on future expenses and income that are not in the accounts yet.
However, traditional accounting is available to all businesses. It is also more widely recognised as it has been used for far longer. Traditional accounting also allows businesses to have a clearer idea of their total revenue as it takes into account expenses such as wages and rent that are made throughout the year.
Traditional accounting also has more access to capital allowances, which means the businesses can get more money off equipment that is invested in for long term use.
The main difference between cash-basis and traditional accounting is that cash-basis only includes transactions that have been made and completed, whereas traditional accounting includes credited transactions that have you to be made.
Both methods have pros and cons, but cash-basis accounting is the simpler of the two. However, it is reserved for businesses that turnover less than £150,000 per year. Traditional accounting is more complex, but more thorough and is recognised as the standard method.
Whether you opt for cash-basis or traditional accounting will largely depend on the size of your business, the complexity of your accounts, and the systems that you already have in place.