What’s the difference between accruals basis accounting and cash basis accounting?
If you’re a small business owner or landlord, you may have heard of the two methods of accounting: accruals basis accounting, which is sometimes called ‘traditional accounting’, and cash basis accounting. In this guide, we explore the key differences between these two accounting methods and the factors to consider when choosing which to use.
Differences between accruals basis and cash basis accounting
The main difference between accruals basis accounting and cash basis accounting is the date upon which you record your income and costs.
Under the accruals basis of accounting, businesses and landlords record their income at the date displayed on invoices issued and on bills received.
Under the cash basis of accounting, businesses and landlords record their income and costs at the date the money comes in or is paid out.
Who can use cash basis accounting?
If you’re a business owner, you can usually use the cash basis of accounting if you meet both of the following criteria:
- You are a sole trader, or your business is a partnership that has only individuals as partners.
- You have a total annual turnover of £150,000 or less from all your businesses. This figure doesn’t include any income you earned from property, which is considered separate for these purposes.
If you have more than one business and wish to use cash basis accounting, you must use it for all your businesses. However, if you’re both a landlord and a business owner and use the cash basis of accounting for your property income, you’re still allowed to use accruals basis accounting for your business income.
VAT-registered sole traders and partnerships can also use the cash basis of accounting. This is different from using the cash basis to prepare your VAT returns, so please check with your accountant if you’re unsure which basis you should be using for your accounts.
Limited companies and limited liability partnerships, along with some other specific types of business, can’t use the cash basis of accounting.
If you’re an unincorporated landlord (i.e. your properties are not owned by limited companies), you must use the cash basis of accounting, unless either:
- your gross income from property exceeds £150,000 per year
- you indicate on your Self Assessment tax return that you do not wish to use cash basis accounting
As limited companies are not allowed to use cash basis accounting, incorporated landlords (whose properties are owned by a limited company) must use the accruals basis of accounting.
Who can use accruals basis accounting?
HMRC will presume that a business is using accruals basis accounting unless the owner makes an election to use cash basis accounting. Business owners can do this by marking the relevant box when filing their tax return.
Unincorporated landlords (landlords whose properties are not owned by limited companies) who want to use accruals basis accounting must indicate that they wish to do so on their Self Assessment tax return.
As limited companies cannot use cash basis accounting, incorporated landlords must use the accruals basis of accounting.
Choosing an accounting method
The accounting method you choose to use is likely to depend on your circumstances as a business owner or landlord.
Some people find the cash basis of accounting the easier method to understand, because it involves recording income and costs on the date on which they are received or paid. It provides a clearer picture of how much cash is available in a business at any given time. Under the cash basis of accounting, Income Tax is only due on money that’s been received, which means that business owners and landlords aren’t taxed on unpaid invoices at the end of the tax year.
HMRC doesn’t allow businesses with a combined business turnover (excluding property) of more than £150,000 per year to use cash basis accounting. Therefore, if you expect your business turnover to increase substantially in the near future, the cash basis of accounting may not be a long-term solution. If you’re already using the cash basis of accounting and you pass that threshold, you can stay in the scheme up to a combined business turnover of £300,000 per year, after which you’ll need to switch to accruals basis accounting for your next Self Assessment tax return.
There’s a variety of additional circumstances in which cash basis accounting may not be the best choice for a business. If you’re in any doubt as to which accounting method to choose, we recommend that you speak to an accountant.
Choosing an accounting method in FreeAgent
FreeAgent supports both cash basis accounting and accruals basis accounting. When you set up a sole trader or partnership account, you can choose which accounting method to use.
Disclaimer: The content included in this guide is based on our understanding of tax law at the time of publication. It may be subject to change and may not be applicable to your circumstances, so should not be relied upon. You are responsible for complying with tax law and should seek independent advice if you require further information about the content included in this guide. If you don't have an accountant, take a look at our directory to find a FreeAgent Practice Partner based in your local area.