When running a business, one of the key questions is when income and costs should be recorded.
There are two main methods:
- Cash accounting
- Accrual accounting, also known as traditional accounting
Both methods can be correct, but they work differently. The right option depends on the type of business, how complex the records are, whether the business is VAT registered, and whether the figures are needed for tax, management accounts, finance applications or business planning.
What is cash accounting?
Cash accounting records income and expenses when money is actually received or paid.
For example, if you invoice a customer in March but they pay you in April, the income is recorded in April under cash accounting.
HMRC says cash basis accounting is the standard way to record income and expenses for sole traders and partnerships without corporate partners, although some businesses cannot use it, such as limited companies.
Example
You send a customer an invoice for £1,000 on 20 March.
They pay you on 10 April.
Under cash accounting, the £1,000 is recorded when the payment is received on 10 April.
What is accrual accounting?
Accrual accounting records income and expenses when they are earned or incurred, not when the money is paid.
For example, if you invoice a customer in March but they pay you in April, the income is recorded in March under accrual accounting.
HMRC refers to this as traditional accounting. Under traditional accounting, income and expenses are recorded by the date invoiced or billed.
Example
You send a customer an invoice for £1,000 on 20 March.
They pay you on 10 April.
Under accrual accounting, the £1,000 is recorded on 20 March, when the invoice was raised.
Cash Accounting: Pros and Cons
Pros of cash accounting
1. Easier to understand
Cash accounting is usually simpler because it follows the bank account.
Money in equals income.
Money out equals costs.
For many smaller businesses, this is easier to follow than adjusting for unpaid invoices, creditors, debtors, stock and prepayments.
2. Helps with cash flow
Cash accounting can be helpful because tax is generally based on money actually received.
This means a business should not normally pay tax on income that has been invoiced but not yet paid.
For small businesses with slow-paying customers, this can make a real difference.
3. Less administration
There are usually fewer year-end adjustments compared with accrual accounting.
This can make bookkeeping simpler and reduce the amount of work needed to prepare the accounts.
4. Useful for straightforward businesses
Cash accounting often works well for sole traders, small partnerships and businesses with simple transactions.
Examples include:
- consultants
- tradespeople
- small service businesses
- businesses with little or no stock
- businesses where customers pay quickly
Cons of cash accounting
1. It may not show the true position of the business
Cash accounting only shows what has been paid and received.
It does not always show what the business is owed or what it owes to others.
This can make profit look better or worse than it really is.
2. It can distort profits between years
If a large customer pays late, income could move into the next tax year.
If a large supplier bill is paid early, the cost could fall into the current tax year.
This can make one year look unusually profitable and another year look unusually low.
3. Not suitable for every business
Cash accounting may not be suitable where the business has:
- high stock levels
- finance agreements
- large unpaid invoices
- complex contracts
- significant work in progress
- bank lending requirements
HMRC notes that traditional accounting may be preferred where the business is complex or needs finance, as a bank may want accounts showing what the business owes and what it is owed.
4. Limited companies cannot usually use cash basis for corporation tax accounts
Cash basis accounting is mainly relevant for sole traders and certain partnerships.
Limited companies normally prepare accounts using accrual accounting.
Accrual Accounting: Pros and Cons
Pros of accrual accounting
1. Gives a fuller picture
Accrual accounting shows income earned and costs incurred, even if the cash has not yet moved.
This gives a better picture of profit and business performance.
2. Better for management accounts
Accrual accounting is usually better for reviewing the business.
It can show:
- unpaid customer invoices
- unpaid supplier bills
- stock
- prepayments
- accruals
- work in progress
- a more accurate profit figure
This is useful when making decisions.
3. Often required for limited companies
Limited companies normally prepare accounts using accrual accounting.
This gives a more formal and complete view of the company’s financial position.
4. Better for finance applications
Banks, lenders and investors often prefer accrual-based accounts.
This is because they can see not just the bank balance, but also debtors, creditors and future commitments.
Cons of accrual accounting
1. More complicated
Accrual accounting usually needs more adjustments.
For example:
- sales invoices not yet paid
- supplier bills not yet paid
- stock
- prepayments
- accruals
- depreciation
- capital allowances
This makes the accounts more accurate, but also more involved.
2. Tax can be due before the customer has paid
A business may be taxed on income that has been invoiced, even if the customer has not yet paid.
This can create cash flow problems, especially where customers are slow to pay.
3. More bookkeeping discipline is needed
Accrual accounting works best when records are kept properly throughout the year.
Invoices, bills and bank transactions all need to be recorded correctly.
Cash Accounting v Accrual Accounting: Simple Comparison
| Area | Cash Accounting | Accrual Accounting |
|---|---|---|
| Income recorded | When paid | When invoiced or earned |
| Costs recorded | When paid | When billed or incurred |
| Simplicity | Usually simpler | More detailed |
| Cash flow | Often better for tax timing | Can create tax before cash is received |
| Accuracy | Less complete | More accurate |
| Best for | Simple small businesses | Limited companies, larger or more complex businesses |
| Shows debtors and creditors | Not fully | Yes |
| Useful for finance | Less useful | Usually better |
What about VAT?
VAT has its own rules.
A business can use normal VAT accounting or, if eligible, the VAT Cash Accounting Scheme.
This is separate from whether the business prepares its accounts on a cash or accrual basis.
Standard VAT accounting
Under standard VAT accounting, VAT is usually included on the VAT return based on the invoice date.
This means:
- VAT on sales is payable to HMRC when the sales invoice is raised
- VAT on purchases is reclaimable when the purchase invoice is received
The issue is that a business may have to pay VAT to HMRC before the customer has paid the invoice.
Example
You invoice a customer £1,000 plus VAT of £200 in March.
The customer pays in May.
Under standard VAT accounting, the £200 VAT may need to be included on the March VAT return, even though the customer has not paid yet.
VAT Cash Accounting Scheme
Under the VAT Cash Accounting Scheme, VAT is based on payment dates.
This means:
- VAT on sales is paid to HMRC when the customer pays you
- VAT on purchases is reclaimed when you pay the supplier
This can help cash flow, especially where customers take time to pay.
HMRC says a business can use VAT cash accounting if it is VAT registered and estimated VAT taxable turnover is £1.35 million or less in the next 12 months. The business must leave the scheme if VAT taxable turnover is more than £1.6 million.
VAT thresholds
The current UK VAT registration threshold is more than £90,000 of taxable turnover. VAT taxable turnover is the total value of sales that are not exempt. The VAT deregistration threshold is less than £88,000.
For VAT schemes, the main thresholds are:
| VAT scheme | Threshold to join | Threshold to leave |
|---|---|---|
| Flat Rate Scheme | £150,000 or less | More than £230,000 |
| Cash Accounting Scheme | £1.35 million or less | More than £1.6 million |
| Annual Accounting Scheme | £1.35 million or less | More than £1.6 million |
These VAT scheme thresholds are based on taxable turnover.
VAT Cash Accounting: Pros and Cons
Pros of VAT cash accounting
1. Better cash flow
The main advantage is that VAT is paid to HMRC after the customer pays.
This can be very helpful where customers take 30, 60 or 90 days to pay.
2. Reduces the risk of funding VAT from your own money
Under standard VAT accounting, you may have to pay VAT to HMRC before being paid by the customer.
Cash accounting reduces this problem.
3. Useful for businesses with slow-paying customers
VAT cash accounting can work well for:
- consultants
- contractors
- trades
- agencies
- service businesses
- businesses with credit terms
Cons of VAT cash accounting
1. You reclaim VAT later
You can only reclaim VAT on purchases when you have paid the supplier.
If you regularly buy stock or equipment on credit, this could delay your VAT reclaim.
2. It may not suit businesses with high upfront costs
If a business has large purchase invoices and wants to reclaim VAT quickly, standard VAT accounting may be better.
3. Some transactions are excluded
HMRC lists exceptions where VAT cash accounting cannot be used, including certain hire purchase, lease purchase, conditional sale and credit sale transactions.
4. You must monitor the threshold
A business can join the VAT Cash Accounting Scheme if estimated taxable turnover is £1.35 million or less, but must leave if taxable turnover goes over £1.6 million.
Which method is better?
There is no single answer.
Cash accounting may be better if:
- the business is small and straightforward
- customers pay at different times
- cash flow is important
- there is little or no stock
- the business is a sole trader or simple partnership
- the owner wants simpler records
Accrual accounting may be better if:
- the business is a limited company
- the business carries stock
- there are large unpaid invoices or supplier bills
- the business needs management accounts
- the business is applying for finance
- the owner wants a clearer picture of true profit
VAT cash accounting may be better if:
- the business is VAT registered
- customers take time to pay
- the business does not have large unpaid supplier bills
- the business wants to avoid paying VAT before being paid
Standard VAT accounting may be better if:
- customers pay quickly
- the business has large purchases
- the business often reclaims VAT
- supplier invoices are received before they are paid
- the business wants VAT returns based on invoice dates
Final thoughts
Cash accounting is simple and can help with cash flow.
Accrual accounting gives a more accurate view of business performance.
For VAT, the Cash Accounting Scheme can be very useful where customers are slow to pay, but it also means VAT on purchases is only reclaimed when suppliers are paid.
The best approach depends on the business, the records, the VAT position and what the accounts are needed for.
For many small businesses, cash accounting can be practical and easy to follow. For more complex businesses, limited companies, or businesses needing clear management information, accrual accounting is usually the better option.
