In 2023, the UK government held a consultation on the current income tax monetary base rules to explore how they could be simplified and expanded.
Before the new tax year, which began in April 2024, more than two-thirds of eligible businesses were not officially using the cash method and many were able to benefit from it.
So this is an opportunity for the government to simplify taxation for small businesses while making taxes digital.
The new rule changes are intended to reduce the complexity of using cash.
If you are a small business owner wondering how these changes will impact you, this article will inform you about the two accounting methods (cash basis and accrual basis) and what you may need to do to accommodate the future changes.
Here’s what we cover:
What has changed in cash accounting?
Four key changes emerge from the results of this consultation.
They affect all unincorporated businesses in the UK, i.e. individuals who are self-employed or partners in a partnership.
- Cash basis is the standard method of calculating taxable profits. The default was the accrual method, but now that the changes are taking effect, companies will have to waive the default on their tax return to continue using the accrual method.
- The turnover thresholds for companies to use the cash base have been completely eliminated. Previously, turnover had to be under £150,000 to switch to cash basis. Once a company reached a turnover of £300,000 it had to switch to the accrual basis.
- The previous £500 limit on interest deductions for cash payments has also been removed. Since there are no restrictions on accrual accounting, this aligns the two methods.
- The previous restrictions on claiming compensation for losses incurred on a cash basis have been lifted. This also adapts it to the rules of accrual accounting.
When did the changes come into effect?
These changes came into effect on April 6, 2024, the start of the 2024/25 tax year.
This means they are applicable if you file your self-assessment tax return before January 31, 2025.
Cash basis vs. accrual accounting
Cash accounting and accrual accounting are two different methods of recording financial transactions in accounting.
They differ in when they record income and expenses.
The choice between the two depends on factors such as the size of the company and the need for a deeper understanding of financial performance.
Cash basis
On the cash basis, you only record transactions if there is actually an inflow or outflow of cash. This means that income is recorded at the time money is received and expenses are recorded at the time they are paid.
This method is straightforward and designed for small business owners with simple transactions, such as web designers, taxi drivers, and consultants.
One of the disadvantages of the cash basis is that it does not meet these standards and you may be required to prepare accounts according to these accounting standards for another purpose.
For example, when asking a bank for a loan, you will generally want to see a full set of UK Generally Accepted Accounting Principles (GAAP) accounts with a balance sheet to demonstrate the company’s borrowing strength.
Accrual accounting
Accrual accounting, on the other hand, records transactions as they occur or are earned, regardless of when the money is received or paid out.
This means that you typically recognize revenue at the time you invoice the customer, rather than when you receive payment for the invoice (which could potentially be months later).
Accrual accounting is beneficial because it provides a more accurate picture of financial performance and position.
The accounts show more accurately when income and expenses were actually incurred each month, as well as the debtor and creditor positions at the end of the period.
It is advantageous to use this method when selling inventory to reconcile income with associated expenses – the cost of goods sold is recognized at the same time as income from the goods.
The disadvantage of accrual accounting is that it requires more complex accounting and requires estimates and adjustments for items such as accruals, prepayments, and depreciation.
Accrual accounting is generally required to comply with accounting standards such as UK GAAP and International Financial Reporting Standards (IFRS), making it suitable for more complex businesses that need to comply with these standards when preparing financial statements.
What companies should do now and who can support them
If you are self-employed (sole trader) or partner in a partnership, cash payment will be the standard method of creating taxable profits on your tax return from the 2024/25 tax year.
However, that doesn’t mean you have to switch to the cash basis when creating accrual accounts.
Before taking action to change your accounting method, you should always consult a professional, such as an accountant or tax advisor, as this may have unforeseen consequences.
An accountant can explain the advantages and disadvantages of cash accounting versus accrual accounting and tell you which method is better for your business.
If you discuss the best option with your accountant and decide to continue using accrual accounting, the only change required when filing your tax return is to select the option to opt out of the standard cash basis.
On the other hand, you may have unknowingly already prepared your tax return on a cash basis and may not have checked the cash basis box on the tax return.
In this case, too, you don’t have to do anything differently in the future.
If you and your accountant decide that it is beneficial to switch from accrual accounting to cash accounting, some income and expense adjustments will be necessary in the first year to ensure that you are accurately accounting for all income and expenses.
Payments to your suppliers in the cash basis period may include, for example, the payment of amounts owed for purchases that were already recorded in the previous tax year.
Therefore, these payments must be deducted from the cash accounts, otherwise the expenses will be counted twice.
Your accountant can help you make these adjustments and give you advice on how to manage your accounts and bookkeeping on a cash basis.
Final Thoughts on Cash Basis Changes
It is important to understand that there are pros and cons when it comes to using cash.
Even though this is the easier method of filing your taxes, that doesn’t necessarily mean it’s the best option for your business.
So before you decide to change your accounting method, it’s important to first speak to a qualified accountant.
They can advise you on the best way to proceed based on the complexity of your business and whether you need to prepare UK GAAP financial statements for other reasons.
Editor’s Note: This article was first published in January 2024 and has been updated for relevance.