Every business records its income and expenses so the business owners can calculate how much money they’re making and what tax they need to pay. Cash accounting is often used as an accounting method by small businesses that want to keep their financial affairs simple.
What is cash accounting?
When small businesses use cash accounting they will record income in the period when it’s received and expenses in the period when they’re paid rather than when the transaction takes place.
For example, in a cash accounting business, you would issue an invoice for goods or services, but for accounting purposes, you wouldn’t record the transaction in your books until the invoice is physically paid by your customer. Similarly, with expenses you might order products from a supplier and they would send you an invoice with 14 days payment terms on it. You wouldn’t record a payment for that invoice until you actually make the payment.
Cash accounting vs. accrual accounting
Under the accrual accounting method, a company records revenue or expenses before any cash changes hands. For example, if you create a sales invoice, you would record that at the date you raise it in their accounts ledger under accounts receivable as monies due to your business. Similarly, with an expense you would record it on the date you receive a bill or invoice from your supplier rather than the date it gets paid. This would be recorded in accounts payable as a debt you owe.
The advantages of cash accounting
Improved cash flow is one of the major advantages of using cash basis accounting because you know exactly what you have in the bank. With accrual accounting, you have to factor in future payments. For example, if you’re VAT registered and operate on a cash basis you don’t have to pay VAT until you actually receive payment from a customer (more of which below). However, it does mean you can’t reclaim VAT on purchases you make from a supplier until you’ve paid the bill.
In addition, cash basis accounting is a simpler way of recording income and is beginner friendly. If you’re new to business and accounting, it can be easier to start this way then move to accrual accounting as your business grows.
VAT cash accounting scheme
If you turn over more than £85,000 a year, you have to pay VAT to HMRC. Under the Cash Accounting VAT scheme you pay VAT or reclaim VAT on the basis of when payments were made or received. Under the Standard VAT Scheme a business’s VAT is recorded at the date an invoice is raised or a VAT invoice is received, not when payment is made or received. It means you might have to pay VAT bills before you’ve been paid the cash needed to do so.
The scheme also can’t be used on the following transactions:
- Transactions with payment terms longer than six months
- Goods imported from the EU
- Goods moved outside a customer’s warehouse
- VAT invoices raised in advance
Cash accounting FAQs
What is an example of cash accounting?
Ginger’s restaurant receives a bill for £2,000 for electricity. Under cash basis accounting that bill is not recorded in their accounts until it is paid, i.e. cash changes hands or an electronic transfer is made. If they were to use accrual accounting it would be recorded in their accounts payable on the date they received the bill.
What is the cash accounting limit for VAT?
HMRC’s VAT scheme, when using cash basis accounting, is only available for businesses with an annual VAT-taxable turnover under £1.35 million.