What is cash accounting?

Accounting for your business income and expenses need not require specialist bookkeeping skills. All you need to do is to use the cash accounting method if you run a small business and want to work out your taxable profits at the end of a tax year. Cash method accounts are among the simplest ways of keeping your books in good order, so can you take advantage of them?

A small business may be able to do their accounting using cash methodologies so long as they fulfil certain criteria. Lots of small business owners use it for tax purposes and to make sure that what is in their bank account matches their income statement and declaration of expenses. The cash basis accounting method is not allowed by the UK tax authorities in all cases, however. You can only use the cash technique if your business is relatively straightforward to account for and your tax declaration will conform to certain rules. The cash basis system is preferable because you don’t need accounting expertise like you would with an accounting method such as the accruals basis, for example.

Using the cash system for accounting versus accrual accounting

The cash basis system differs from accrual accounting significantly. The accruals basis means accounting for revenue, credit, income and expenditure when they are incurred. In other words, if you issue a credit note to a customer or send them an invoice for payment, then you must account for it immediately under the accrual method. With the cash basis method, this is not the case. With the so-called cash system, accounting is only needed when payments are made. As such, your taxable income is worked out according to your actual income and expenses.

With the accrual method, revenue and expenses are accounted for immediately. This usually means the method is suited to a larger organisation with a finance department which pay suppliers and accounts for inventory, cash flow and revenue on a daily basis. Accrual accounting is required by the IRS in the US for businesses over a certain size. In the UK, HMRC will expect accruals basis accounting if you want to offset losses from past tax years against your future tax payments. For many self-employed people, however, the accrual method is not required.

Who is allowed to use the cash accounting system?

Under Generally Accepted Accounting Principles – known as GAAP – most large businesses will need to produce accrual accounts when they pay their tax. Nevertheless, the cash method is deemed to be good enough by HMRC for most smaller enterprises. It is best to talk to a tax advisor or a qualified accountant if you are unsure whether you need to use cash accounting or the accruals basis.

HMRC’s rules states that all self-employed people who work in a sole trader business or in a partnership may be eligible to calculate and pay tax according to the cash method of accounting. However, your turnover will have to be beneath £150,000 per annum – as of 2018-19 – in order to take advantage of this simpler method. Bear in mind that this threshold is set by your total receivable income regardless of what profit you might have made. Even if your profit was very low, then your bookkeeping will need to use the accrual accounting method if your gross income exceeds the threshold.

Some people run more than one business. Bear in mind that HMRC will allow you to use cash-basis accounting if each business has total receipts under the threshold. However, if all of the different businesses have a total turnover that is more than £300,000, regardless of any debits, then you will not be allowed to use this method. In addition, there are certain types of business which are never allowed to use the cash basis system regardless of the size of transactions they make over the course of a year. The common ones that may not use the cash ledger accounting method are:

• Companies engaged in mineral extraction.
• Securities dealerships.
• Farmers and creatives who use a 221 ITTOIA financial statement.
• Any business that has made use of a research and development grant.
• Enterprises working in the waste disposal sector.
• Ministers of religion.
• Businesses providing crematoria services.
• Any organisation that has made use of a premises renovation allowance.

How to use the cash method for keeping accounts

Although cash is seldom used these days to settle payable bills, the cash method keeps track of actual transactions that have been made rather than when bills and sales invoices are generated. This way, you only account for expenditure and sales when money changes hands, not when the cost has been incurred.

For example, you might buy stock from a wholesaler which affords you 30 days of credit before you have to pay for it. Let’s say you sell this stock within 15 days to customers who are also given 30 days credit before they need to pay. In this example, some customers might settle their bill on time, some might not. You might pay your supplier on time, or a little late, depending on the exact circumstances. It is quite hard to keep a clear idea of your cash flow position in such a situation unless you have lots of experience with managing income and accounting for expenses.

With the cash basis approach, you only enter a transaction in your ledger when a bill is paid, either to a supplier or by a customer. This way, your business deductions can be added up at the end of the year easily. Just deduct all of your business expenses from your total revenue from your payments and you can work out your taxable income. As such, the cash basis is one of the simplest accounting methods around.