The financial records you keep for your business consist of income and expense accounts which show how much money comes in and goes out. The way you record transactions in these accounts and how you report them on your tax return depends on whether you use cash basis or traditional accounting.

In this article we’ll explain the two different types of accounting scheme so you can decide whether the cash basis or traditional accounting method is best for you.

What is cash basis accounting?

Using the cash basis method of accounting means your income and expenses are ‘recognised’ at the point you actually receive or pay the money. For example, if you send an invoice today and your customer pays in 30 days’ time, then you would recognise the income at the point of payment rather than when you sent the invoice out.

It’s the same principle if you order something from a supplier; the purchase is recognised at the point you make the payment, rather than when you receive the order or the date on the invoice.
 

Can my business use cash basis accounting?

 
Cash basis accounting isn’t for everyone, and there are restrictions as to who can use this method. You can use cash basis accounting if:

• You operate as a sole trader or a partnership. Limited companies are not allowed to use cash basis accounting.
• The turnover for your business is £150,000 or less per year when you start using this method. If you join the scheme and your business grows, you can continue using cash basis accounting until your total turnover reaches £300,000.

Can I use different accounting schemes for different businesses?

 
If you have more than one sole trader or partnership business, you’ll need to use the same accounting scheme for each of them. Sole traders and partners aren’t legally separate from their business in the way that the owner of a limited company is, so you’ll need to include each enterprise on your Self Assessment tax return (which is why consistency in your accounting methods is important!).

You can only start using cash basis accounting for your businesses if their combined total turnover is less than £150,000.

What is the traditional accounting method?

Traditional accounting is where transactions are recorded in your bookkeeping using the date on the invoice or bill. Basically, if you create a customer invoice, it’s recorded as income on that day – even if the customer hasn’t paid you yet.

The same goes for costs. When you incur costs, they’re recorded using the date on the invoice whether or not you’ve paid. There’s a twist here though, because we also need to think something called accruals. Brace yourself – we’re getting technical.
 

What are accruals?

Accruals are a way of accounting for bills we know we’ll need to pay in the future even though we’re incurring the expense now. A good example of this is a power-intensive business using lots of electricity, which hasn’t received a bill yet.

It’s likely to be for a substantial amount of money, but under the cash basis method of accounting you won’t record it in your bookkeeping until you actually pay the bill.

As a result, your financial reports won’t show a true reflection of what’s going on in your business – which means there’s also a risk you won’t have the money in your bank account to pay the bill.

• Your profit and loss (P&L) account won’t show a true profit picture, because there are still costs you need to record
• The balance sheet won’t be accurate because it doesn’t show the full extent of what the business owes

An example of accruals in the wild

 
Let’s say your business is using £1,000 worth of electricity each month. Depending on what sort of bookkeeping system you use, the type of entry you make to show this as an accrual in your records might be referred to as an ‘adjustment’ or a ‘journal’.

You’ll make an entry against your ‘electricity’ category each month, and then to balance the entry you’ll put the other side of it against liabilities (accruals) on your balance sheet.

You’ll do this until you get a bill, at which point you’ll enter the bill to unwind the transactions. The table below shows how this looks as a series of monthly adjustments.
 

Now in the same way as you can accrue for expenses, you can also accrue for sales. For example, if you supply goods or services before invoicing the customer.

The accrual method means that your balance sheet and profit & loss account will show a more ‘true and fair’ view of how your business is doing. This is important because you don’t want to think you are having a great month, only to find out later that you have a whacking great electricity bill to pay!

What are the downsides of using the accrual method?

 
The accrual method is beloved by accountants because it tends to paint a more realistic picture, so why doesn’t everybody use it? Well in truth, the majority of larger businesses do use the accrual method but there are some downsides.

As we saw above with a very simple example, it takes a while to get your head around things. If you have a lot of accruals of both income and expenses, then it can take a lot of administering. This means that you may need to employ someone who has more specialised accounting knowledge.

There also tends to be a gap between how the profit and loss report looks and what is in the bank account. With that in mind, you may find it helpful to produce a separate cash flow forecast which will help you identify the difference between what you expect to make, and the money that has actually hit your bank account.

Keeping track of what customers owe you is also a key aspect to keep on top of, so good bookkeeping (as always) is a must!

Cash basis versus traditional accounting: which one is right for my business?

There isn’t really a straightforward answer to this because it depends on the business itself. For example, a smaller business or start up might find it easier to record transactions using cash basis accounting, because then you’ll only need to pay tax on the money that you actually receive. So, if you run a business in an industry where customers tend to pay their invoices a bit later, you won’t pay tax on that income until they actually pay you.

On the other hand, a small business which buys stock in the morning and then sells it during the day won’t really have much to gain from this method!

The cash method might also be inappropriate for your business if you’re planning to apply for finance. This is because any lender will want to see a fair representation of your accounts before agreeing to anything.

It’s always a good idea to chat with an accountant to go through things in more detail. They can also help you set up bookkeeping systems, and train you (and any staff) in using them.

 
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Elizabeth Hughes

A content writer specialising in business, finance, software, and beyond. I'm a wordsmith with a penchant for puns and making complex subjects accessible.