Cash Based Accounting, have you heard of it? Tax rules change. They evolve. Sometimes, they even simplify our lives. In our previous blog post on cryptocurrencies, we explored how complicated HMRC regulations can get. We looked at the digital frontier and the tax headaches it creates.
Today, we bring it back to basics. We are looking at a fundamental shift in UK tax reporting for unincorporated businesses.
For many of you, cash basis accounting is now the default. It is the new standard method for calculating your taxable profits.
This sounds good on paper. Simplicity is usually a win. However, default does not mean mandatory. Furthermore, default does not always mean “best.”
You need to understand the rules. You need to know if you are excluded. Most importantly, you need to know when to say “no” to the default and stick with the traditional methods.
The Landscape Has Changed
In the past, the accrual basis was the standard. You had to actively choose the cash basis if you were eligible. The tables have turned.
Now, HMRC assumes you are using the cash basis. If you are a sole trader or a partnership made up entirely of individuals, you fall into this bucket automatically. You do not need to tick a box. You do not need to apply.
But what does this actually mean for your day-to-day bookkeeping?
What Exactly is Cash Basis Accounting?
Let’s strip away the jargon.
Cash basis accounting tracks the actual movement of money. You record income only when it lands in your bank account. You deduct expenses only when the cash leaves your account.
It is immediate. It is tangible.
The Simplicity Factor
This method removes several accounting headaches, for example, there will be no.
- Receivables: You do not need to track money owed to you for tax purposes.
- Payables: You do not need to list money you owe suppliers.
- Accruals or Prepayments: You forget about matching costs to specific months.
You look at your bank statement to see what has actually come in and out of your account. This is essentially your profit. For many freelancers and small tradespeople, this mirrors how they view their business. It feels natural.
Automatic Bad Debt Relief
There is a massive advantage here regarding bad debts.
Under the old rules, you often paid tax on an invoice before the client paid you. If the client went bust, you had to claim relief later. It was a mess.
With the cash basis, this problem vanishes. If a client does not pay, you never receive the money. Therefore, you never record the income. You never pay tax on it. The relief is automatic. It saves you time. It protects your cash flow.
(For more on managing business cash flow, listen to our I Hate Numbers Podcast: Cash is King.)
The Alternative: Accrual Basis
To understand your choice, you must understand the alternative. This is the “Accrual Basis.”
Under the accrual basis, time matters more than cash. You record income when you earn it, and expenses are recorded when you incur them.
You send an invoice in March. The client pays in May. Under accruals, that income belongs to March. You owe the tax for that period. The actual date of payment is irrelevant for the profit calculation.
This sounds complex. However, it provides a more accurate picture of reality. It matches your effort to your reward.
Who is Forbidden from Using Cash Basis Accounting?
Here is the critical part. You might love the sound of the cash basis. But you might not be allowed to use it.
Cash basis accounting is not for everyone. HMRC has a strict list of “excluded businesses.” If you fall into these categories, the accrual basis is compulsory. You have no choice.
The Excluded List
You must use the accrual basis if you operate as:
- A Limited Company: If you are incorporated, cash basis is off the table. (Check out our I Hate Numbers blog on Sole Trader vs Limited Company to see if incorporation is right for you).
- A Limited Liability Partnership (LLP): These structures require formal accrual accounts.
- A Partnership with a Corporate Partner: If one of your partners is a Limited Company, the whole partnership is excluded.
- Specific Farming Businesses: If you claim farming tax reliefs like the “herd basis,” you are excluded.
- Creative Businesses: If you use profit averaging reliefs, you must stick to accruals.
- Complex Corporate Structures: Any business required to use International Financial Reporting Standards (IFRS) is excluded.
If you are on this list, stop reading about the cash basis. It is not for you. You must use accruals.
Why You Should Opt Out
Let’s assume you are eligible. You are a sole trader. You are not excluded. Should you just accept the default?
Not necessarily.
You can “opt out.” You can choose to remain on the accrual basis. For many of our clients at I Hate Numbers, this is actually the smarter strategic move.
Here are five reasons why you might reject cash basis accounting.
1. You Need External Funding
Banks are conservative. Investors are detailed-oriented.
When you apply for a loan or a grant, the lender wants to see your financial health. They want to see your assets. They want to see your liabilities.
Cash basis accounts do not show this. They do not show the £10,000 invoice you are waiting for, nor the £5,000 you owe a supplier. Furthermore, they only show cash.
To a bank manager, cash basis accounts look incomplete. Accrual accounts show a complete picture. They prove your business is solvent. They prove you have future income secured. If you want to grow using other people’s money, stick to accruals.
2. You Manage Long-Term Projects
Imagine you are a web developer or a builder. You work on a project for six months, incurring costs in months one through five. Finally, you get paid in month six.
Under the cash basis, months one to five look like losses. Month six looks like a massive profit. Your accounts look like a roller coaster.
The accrual method smooths this out. It matches the costs of the project to the revenue. It allows you to track profitability accurately. You can see if a project is actually making money while you are doing it.
3. High Stock Levels and Volatility
Do you hold a lot of inventory?
Retailers and wholesalers often have shelves full of stock. Levels fluctuate. You buy heavily before Christmas. You sell heavily in January.
The accrual basis handles this gracefully. It values your stock at year-end. It calculates your “Cost of Goods Sold” accurately. This allows you to track your Gross Profit Margin.
If you use the cash basis, buying stock is just an expense. Buying a huge order reduces your profit immediately. It distorts your margins. You lose the ability to analyze your business performance.
4. Dealing with Credit
We mentioned bad debts earlier. However, there is a flip side.
If you buy assets or stock on credit, the cash basis can hurt you. You generally cannot claim tax relief until you make the payment.
Imagine you buy a £20,000 van on a finance lease. You haven’t paid the cash yet. Under the cash basis, you get no tax relief yet. Under the accrual basis, the obligation is recognized. You may be able to claim capital allowances sooner.
Additionally, if you give customers credit, accrual accounting tracks exactly who owes you what. It forces you to manage your sales ledger. Cash accounting can make you lazy with credit control.
5. Future Incorporation Plans
Do you plan to grow?
Many sole traders eventually become Limited Companies. As we discussed, companies must use accrual accounting.
If you use the cash basis now, you will have a headache later. When you incorporate, you will have to transition your accounts. You will have to ensure income isn’t taxed twice (once when earned as a sole trader, again when received as a company). You will have to ensure expenses aren’t missed.
It is messy. It is expensive.
If you stay on the accrual basis now, the transition to a Limited Company is seamless. The accounting principles remain the same. You compare apples with apples.
The VAT Disconnect
There is one final “gotcha.”
Income Tax and VAT are different beasts. They do not always talk to each other.
There is a “Cash Accounting Scheme” for VAT. This is separate from cash basis accounting for Income Tax.
- You can use the Cash Basis for Income Tax.
- You can use the Accrual Basis for VAT.
- Or vice versa.
This flexibility is useful, but it can be confusing. For example, you might be recording an invoice one way for your VAT return and another way for your Self Assessment.
(We dive deeper into this in our I Hate Numbers blog: VAT Schemes Explained—it is worth a read to ensure you aren’t crossing your wires).
Conclusion
The shift to cash basis accounting as a default is a move towards simplicity. For the smallest businesses, the “side-hustlers,” and the simple freelancers, it is a welcome change. It makes the tax return less scary.
However, simplicity comes at a cost. It costs you visibility. It costs you detail.
If you are a serious business owner with growth ambitions, look before you leap. Do not just accept the default because it is easy. Consider your inventory, need for loans, and your future plans.
If you are excluded, your path is clear. If you are not, the choice is yours. Make sure it is an informed one.
I have written a book for you, called “I Hate Numbers“. One readers quote
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