You’ve taken the plunge and signed up for FreshBooks, Xero, QuickFile, Sage, KashFlow, QuickBooks, or one of the many other accounting software solutions. Congratulations! The world is your oyster, and some great perks await you on your new bookkeeping journey for your business. You’ve opened the door to automating some of what you previously had to enter manually, saving yourself time, and reducing errors. Hooray!
However, on about the second or third screen of setup, it’s asking you whether you use accruals or cash accounting. What is that, you think to yourself, and a quick google later, you’re here.
I made a video on this question, or you can read more below.
The difference is when the income or expense is counted for tax purposes (and VAT purposes, if you’re VAT-registered). Which year or quarter are you tallying that sale or expense?
If you buy or sell on credit, then you need to decide which to use; if all your sales and expenses are paid for immediately, then it doesn’t matter. (“On credit” means either that you’re invoicing your customer and waiting for payment or that your supplier is invoicing you and waiting for payment. It has nothing to do with if a sale or expense is paid for with a credit card. In accounting, credit card sales and expenses are considered as immediate payments, also called cash transactions. I’m sorry; I know it isn’t very clear.)
Most of the time, it doesn’t matter. But if you issue an invoice on or before 5 April and your customer pays on or after 6 April, then it matters in working out which tax year you count the income or expense. If this doesn’t happen too much to you, stick with accruals accounting. Every software system supports it throughout (some software only partially supports cash accounting), so it will make your life easier in the long run.
Accruals / Traditional Accounting
Accruals-based accounting is the default. If you use accruals, then the invoice date dictates when the income or expense is counted in your accounts.
- Using this, if you’ve issued an invoice to a customer on 31 March, and they pay it on 7 April, then you count that sale in the earlier tax year.
- Likewise, if you receive an invoice from a supplier dated on 31 March, and you pay it on 7 April, then you claim the tax relief for it (as a business expense) in the earlier tax year.
There can be a disadvantage to the cash flow of a small business that needs to pay tax on income it hasn’t yet received, so cash accounting is an option.
Cash Accounting
If you use cash-based accounting, then it’s the payment date that dictates when the income or expense is counted in your accounts.
- Under this scheme, if you’ve issued an invoice to a customer on 31 March, and they pay it on 7 April, then you count that sale in the later tax year.
- Likewise, if you receive an invoice from a supplier dated on 31 March, and you pay it on 7 April, then you claim the tax relief for it (as a business expense) in the later tax year.
The advantages and disadvantages of this are:
- You’re not paying tax on sales you haven’t yet been paid for.
- You’re not receiving tax relief on any expenses you haven’t yet paid for.
In practice, your tax payments are due nine months after the end of the financial year, so hopefully, you have received payment for any sales by then. If not, it’s time to start considering writing the sale off as a bad debt! As such, there’s not much incentive that I can see for adopting cash accounting.
You can, however, run reports on either basis from within most software packages. If you buy or sell much on credit, this can be helpful for forecasting your cash flow (that is, working out the pinch points and easier times through the year based on when payments are made and received).
VAT Cash Accounting Scheme
I primarily serve non-VAT-registered sole traders, but if you need to know how this applies to VAT, read on.
If you are VAT-registered, the same concept can apply to when you count the VAT on your sales and expenses. Please check with your accountant before changing your VAT accounting scheme because HMRC has rules surrounding different VAT schemes. Also, switching between schemes needs to be handled carefully to avoid double-counting or missing transactions. At the time of writing, you can use cash accounting if:
- your business is registered for VAT
- your estimated VAT taxable turnover is £1.35 million or less in the next 12 months
You cannot use cash accounting if:
- you use the VAT Flat Rate Scheme – instead, the Flat Rate Scheme has its own cash-based turnover method
- you’re not up to date with your VAT Returns or payments
- you’ve committed a VAT offence in the last 12 months, for example VAT evasion
You cannot use it for the following transactions (you have to use standard VAT accounting instead):
- where the payment terms of a VAT invoice are 6 months or more
- where a VAT invoice is raised in advance
- buying or selling goods using lease purchase, hire purchase, conditional sale or credit sale
- importing goods into Northern Ireland from the EU
- moving goods outside a customs warehouse
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
I also facilitate the Power Pod Roundtable, which is a business discussion group.
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