Change to Cash Basis Accounting for Self-Employed and Sole Traders
On the surface, the switch from accrual to cash basis accounting may seem fairly irrelevant; some may see it as a positive move. It is only when you begin to look below the surface that the potential challenges emerge. Those previously using an accrual basis before the 2024/25 tax year may need to provide additional information to facilitate the switch to cash basis accounting.
Before we look at this change in more detail, it’s essential to recognise that cash basis accounting has been an option for the self-employed, sole traders, and unlimited partnership members since 2013, but accrual basis accounting was the default before the 2024/25 tax year. However, previously, only businesses with total receipts below £150,000 were able to elect to use the cash basis.
Cash basis vs. Accrual basis
The primary difference between cash basis and accrual basis accounting is simple:-
- Cash basis accounting recognises income when received and expenses when paid
- Accrual basis accounting recognises income when it is earned and expenses when they are incurred, regardless of the payment status
Generally, accrual basis accounting tends to be more complex and certain costs can be split between different accounting periods. However, many argue that the accruals system provides a fuller financial picture than the cash-based approach.
HMRC’s mandate for cash basis accounting
Effective April 2024, self-employed individuals, sole traders, and unlimited partnership members will default to the cash basis accounting system. The government has also removed the previous £150,000 entry and the £300,000 exit thresholds for cash basis accounting. Aside from the fact that cash basis will be the default from the 2024/25 tax year onwards, removing the thresholds gives all (unincorporated) businesses the option to switch.
While these are the broad changes, there are several specific adjustments, such as:-
Interest deduction limit
Previously, a £500 interest deduction limit restricted the amount of interest paid that could be offset against business income. This now aligns the ability to deduct all interest paid with traditional accounting.
Loss relief restrictions
Prior to the changes, businesses using the cash basis accounting system had limited loss relief. They can now offset losses against income in the same tax year or carry them back over the previous three years.
Flexibility for different businesses
The removal of the thresholds now gives those owning multiple businesses the option to choose cash or accrual basis for individual businesses.
Financial implications of switching to a cash basis
In theory, switching to cash-based accounting could significantly reduce immediate tax liabilities if, for example, a business earned £50,000 but only £30,000 was received by the end of the tax year. Under the default system, the £30,000 received in the accounting period would count towards tax that year, with the additional £20,000 deferred.
There are other issues to consider which are not so favourable, including:-
- Transition adjustments to prevent double taxation
- Adjustments to avoid double deduction of income/expenses
- Treatment of capital allowances which are not all deductible on a cash basis
Most of these are one-off issues during the transition period but may have a short-term impact on income, profitability, taxation, and cash flow. The situation should be simpler once the switch to a cash basis has been completed.
Looking at the switch on a broader basis:-
- Companies with slow payment cycles and upfront costs will benefit
- Companies with prompt payment cycles but delayed costs will suffer
- Information will relate to the tax year, which may be different to the business financial year
Many self-employed, sole traders, and partnership members may struggle to find any potential downside to the cash basis accounting system. However, we will cover this topic later in the article.
Benefits of cash basis for self-employed individuals and small businesses
As with any tax regulations, specific issues will be relevant to different types of businesses. In general, the benefits of cash basis accounting for the self-employed and businesses are as follows:-
Less complex reporting
Business owners no longer need to account for unpaid invoices or accrued expenses, instead using cash in and cash out as the basis, which simplifies the reporting process.
Cash flow management
In simple terms, aligning cash flow with tax payments should ensure sufficient funds are available, assisting with longer-term financial planning.
Reduced administration
While not as simple as an in-out basis, cash accounting certainly reduces administration. Consequently, there is the potential to minimise accountancy expenses.
Potential deductions
As we mentioned above, the ability to offset more than £500 in interest expenses (after the cap was removed) will reduce many businesses’ tax liability.
Challenges and considerations
Some companies will find it disadvantageous when it comes to cash basis accounting. These include businesses with:-
- High inventory – the cost of goods is recorded immediately rather than when the inventory is sold.
- Delayed payments – where payment for goods and services is delayed, this can cast the business in an unfavourable light.
- Significant capital expenditure – there are limits on deductibility for equipment costs when using cash basis accounting
- Outside funding – investors and financial institutions will still require accrual basis accounts before providing capital
These are a few examples of issues that may arise for different types of companies switching to cash basis accounting. However, at this point, it’s important to remember that there is still the option to remain on an accrual basis. Also, limited companies and limited partnerships are not eligible to switch to cash basis accounting.
Preparing for the switch to cash basis accounting
While there are several technical issues, as we have covered above, for those looking to switch from accrual basis to cash basis accounting, there are also practical issues to consider, such as:-
- Reviewing existing contracts
- Adjusting invoicing cycles
- Updating cash flow software
- Familiarising yourself with cash basis accounting
Many of these adjustments will be one-off events, and it is also essential not to deflect from the benefits of cash basis accounting. The reduction in administrative costs, removal of turnover thresholds, and more focused time on your business should lead to enhanced turnover, profitability, and return on investment.
Cash Basis Accounting – Conclusion
At face value, the switch from accrual accounting to a cash basis, which is the default from the 2024/25 tax year, may seem relatively minor and all positive. As we have summarised above, there are numerous issues to consider, and certain types of businesses will find it more advantageous than others. Consequently, you must take advice from your accountant to manage the switch in a structured and timely manner.
While there will be situations where accrual basis accounting may be the better option, we have a team of experts who can guide you through the process for those looking to switch to the default cash basis.
It’s important to take action sooner rather than later, as we are more than seven months into the current tax year. Feel free to contact us at your convenience, and we can put a date in the diary.