Tim Humphries – Business Tax Specialist
The recent extension of the thresholds for cash basis accounting is likely to result in more small businesses looking to take advantage of this method as a straightforward alternative to the accruals method of calculating taxable profits.
From 6 April 2017, unincorporated businesses with a turnover of up to £150,000 will have become eligible to use the cash basis. Allowing taxes to be paid only on cash which has been physically received, this method will significantly reduce the administrative burden involved in completing the Making Tax Digital quarterly reports.
However, while many businesses will benefit from switching away from the accruals basis, it is essential that they consider the bigger picture to ensure the chosen method takes into account individual business needs. Tim Humphries, associate director at Menzies LLP, sets out the top 10 things to bear in mind when deciding on the best accounting method for a small business.
1 – The differences between the accruals and cash basis accounting methods
Before the introduction of the cash basis accounting method in the 2013/14 accountancy year, all businesses were required to use the accruals method. Otherwise known as the GAAP (Generally Accepted Accounting Principles) basis of accounting, it involves businesses being taxed on invoices raised or work completed during the current accountancy year, regardless of cash actually received. Expenses are also deducted as the expense arises rather than when invoices are actually paid. In contrast, under the cash basis method, businesses only pay tax on income physically received or expense invoices actually paid.
2 – How to use the cash basis
To choose the cash basis accounting method over the traditional accruals basis of accounting, individuals simply need to make an election on their tax return. For businesses which have been using the accruals method, an adjustment will need to be calculated, taking into account both the debtors which they previously paid tax on and their expenses accrued but which were not actually paid. Without this adjustment, under the cash basis method a business would be required to pay taxes on debts once physically received even though they may have already been taxed on them under the accruals basis. This could result in businesses switching to the cash basis being taxed twice, hence the need for the adjustment.
3 – Who should use the cash basis
All unincorporated businesses (self-employed individuals or partnerships) with a turnover of up to £150,000 are eligible to join the cash basis. However, this method offers particular benefits to those who often experience a long delay between raising invoices and receiving payment. For example, barristers and solicitors paid via the legal aid system can sometimes face a wait of two years or more after raising an invoice before receiving payment. This means that under the accruals method they are being taxed on money they have not yet received. Switching to the cash basis allows such professionals to avoid this situation occurring by paying taxes only on payments actually received.
4 – Using the cash basis under Making Tax Digital
The main advantage of the cash basis accounting method is that it allows relatively straightforward businesses, for example taxi drivers and window cleaners, to simplify the process of calculating tax they need to report to HMRC each quarter under Making Tax Digital. As the cash basis only takes into account actual income and expenses, it is relatively simple to look at receipts and expenses, without the need to also consider invoices for monies owed.
5 – Potential limitations of the cash basis accounting method
The increased flexibility the accruals basis affords to more complex businesses requires individuals to give careful thought to which accounting method best complements overall business needs. For example, for those with business loans it is worth bearing in mind that the deduction for interest and other finance costs paid is limited to £500 under the cash basis, whereas under the accruals method there is no monetary restriction, it just needs to meet the standard ‘wholly and exclusively’ test. Moreover, under the cash basis, businesses are only able to carry forward a financial loss to the next available profits, while under the accruals basis this can be offset against other income subject to overall restrictions. The accruals method may also be a more suitable option for businesses who wish to use factoring. Using the cash basis essentially leaves companies without a balance sheet so demonstrating the strength of a business to borrow money may prove more challenging.
6 – Thresholds
Unincorporated businesses with a turnover up to £150,000 (previously £83,000) are now eligible to calculate their tax return using the cash basis, and must switch to the traditional accruals method after their income exceeds £300,000. Once the turnover exceeds the exit threshold the business must revert to the accruals basis in the following year unless their turnover falls below the £150,000 entry threshold once again. With only a narrow window between businesses reaching the upper turnover bracket and the need to change accounting methods, it is crucial that businesses track income and debtors closely over time and put processes in place early to ensure they can capture the necessary information to disclose their income under the accruals method.
7 – The process of switching from the cash basis to the accruals basis
In order to make the switch from the cash basis to the accruals basis the business has to work out its debtors at the start of the year of change. Rather than taxing all of these debtors in the first year, the opening debtors are split across the first six years of using the accruals basis. Normal debtors’ adjustments are then made using this opening figure.
As the cash basis only requires the payment of taxes on cash physically received, the collection of outstanding debts may not have previously been regarded as much of a priority. However, the move from the cash basis to the accruals method requires businesses to pay tax on invoices that have not yet been paid. This should encourage businesses to chase in and raise fees earlier to avoid paying tax on unpaid invoices and work in progress. In order to ensure that businesses are actually in possession of the cash they are paying tax on, it is important that processes are put in place in good time to help keep on top of debts, which could include engaging debt recovery services if necessary.
8 – Other benefits of the cash basis method
The requirement under the cash basis to deduct debtors and work in progress on which the business has previously paid tax could lead to reducing their taxable profits for the first year of change. It is important to remember that a lower level of profit for a particular year could prove detrimental to a business in the event of applying for a bank loan or to an individual if applying for a personal mortgage, with mortgage businesses commonly looking at profits for three year periods.
9 – Flat rate expenses
In addition to the benefits afforded by cash basis accounting, flat rate expenses also allow businesses to simplify the process of calculating the amount they owe to HMRC each quarter. This allows them to use flat rates for costs such as mileage, rather than being required to keep detailed petrol receipts. There are also flat rate expenses in respect of use of home as office and private use of business premises.
10 – Useful resources
The GOV.uk website and the HMRC Business Income Manual at BIM70000 onwards provides further information on how businesses can go about using the cash basis of accounting, as well as a list of specific types of businesses which cannot use the scheme and advice on how to go about switching from the traditional accruals method.
The Government continues to publish further online material on Making Tax Digital, setting out who is likely to be affected, key dates and other useful information allowing businesses to get organised with their taxes.