What is this cash basis thing?
When you complete your self assessment tax return and the self employment section, there is a question about if you have used “the cash basis” to do your accounts.
Here is the approximate transcript.
This is a question that gets asked plenty of times because there is a box in the self-assessment tax return that asks the question whether you have used cash accounting to do your self-assessment and your self-employed accounts in. Cash accounting is exactly what it says on the tin. It says you make your accounting records when you physically receive payment into your business or into your bank account, or into your cash. It doesn’t matter if it’s received via PayPal, received directly into a bank account, received physically in cash or check. It’s when you have received the actual money.
Let’s say for example, you raise an invoice to Mr. and Mrs. Blythe for their daughter’s singing lessons. You raise it at the beginning of the term, but you don’t actually get paid it until near the end of the term, ignoring the annoying part of that. You would only account for that invoice when you received the money from Mr. and Mrs. Blythe. You don’t account for the invoice when it’s raised. Equally, on the other side you account for your costs when you have physically paid for them. Now, that is very easy if you actually pay in cash. It’s very easy if you pay by direct debit or transfer out of your bank account, or indeed if you pay via PayPal, because they’re fairly instant payment methods.
The trick comes if you pay by a credit card, you might have put the cost on a credit card but you haven’t actually paid for it until you pay the credit card bill. If you only pay a credit card bill a certain amount per month, it’s very hard to know whether you’ve paid for which business expense. That’s what cash accounting is. There are problems with it. You have to keep very good records as to know when you physically have paid for things, but in your business, if you make a loss in your business, then you cannot do anything with that loss. It could be your first year of business you’ve had a lot of setup costs, not too many people know about you, so they haven’t employed you very often, but that loss is dead, so you cannot carry it forward to next year and use the loss against any profit in the following year.
It also means if you have purchased any capital items, so a new instrument, a computer, an expensive printer, or various things like that, under the cash accounting rules, it is a cost incurred at that time, because you’ve paid for it at that time, and therefore it goes into the accounts for that tax year. That means you cannot claim any capital allowances. All costs come out of that year. Again, if you make a loss, you cannot carry forward that loss or the capital cost into next year. The only positive side of that is if you’re buying a new instrument on a loan agreement, then technically you’re only putting towards let’s say 100 pounds a month, instead of 3000 pounds for the instrument. You’d actually expense out 100 pounds a month.
That is what cash accounting is. Very simple, because if you were HRMC, they have two hats. They say you have to have the invoices and receipts to be able to do proper accounting, but then under making tax digital, they’re encouraging people just to do their accounts from bank statements. They want their cake and they want to eat it. Now, the other side is what is accrual accounting. This is the correct form of accounting that accountants will use all the time and it is definitely our method of doing accounts. What this is, when you raise the invoice, that is when it hits your accounts.
Mr. and Mrs. Blythe, you have invoiced them in let’s say the beginning of the term, which is January, they didn’t pay you until April, which is the end of the term, but you would account for the income in January, and you ignore when they actually paid the bill, which may be a little harsh because it might be across two tax years, but by the time you actually have to pay the tax on that payment, they should have already paid you. Now, the good thing about that is you base it on a supplier invoice date. Even though you might not pay it until two weeks later, two months later, six months later, you account for it at the time you incur the cost, at the time the liability hits you, really.
There are various accounting rules we can jiggle around with, so if you’ve taken a deposit upfront for something, so I don’t know, you’ve taken a deposit for a concert but the concert’s not until four months’ time, then you can defer that income ’til four months’ time, in order to match the income off with the costs. That gets a bit complicated. Accountants can easily do it. It’s what we’re trained to do. Now, there are great things with that, in that you can have the capital allowances. If you do incur losses, you are able to carry them forward for future years. That is much the preferred method.
However, if you are a limited company, the cash accounting system is not open to you. You can do cash accounting for VAT, that’s a completely separate blog post, but actually to run your accounts and your corporation tax, you cannot use cash accounting. Many people do, because they don’t understand the difference. Several people will do cash accounting throughout the year and their accountant will then pull it back into line to say, “It has to be under an accrual basis.” Cash accounting is really only open to the self-employed.
That’s it. Never tick the “Have you used a cash basis?” on the self-assessment tax return if you are doing the accruals basis, or if you’re doing it, you tend to know when you’ve raised the invoice, that’s when you’re accounting for it. Don’t tick the cash basis, because it may cause problems later on down the line.