There are two ways to calculate profits for partnerships and sole traders namely being cash basis and traditional accounting. This blog will consider these two approaches in terms of which is useful for your business.
Cash basis accounting
Cash accounting is a simpler form in terms of calculating profit and loss by simply recording income and expenditure when they occur.
What cannot be claimed as income or expenditure?
– Expenditure on equipment, vans are recognised as allowable expenses
– Losses from previous year cannot be offset by other income
– The business will not be able to claim capital allowance except on cars
– Interest based on cash borrowing will only be allowable up to £500
Cash basis accounting is useful as it enables your business to assess the actual amount of cash you have at any given time. If a business decides to use cash basis as their method of accounting, and they are eligible for it, then it’s important to tick the ‘cash basis’ box when preparing the self-assessment tax return.
Traditional accounting is different than cash basis as it is based-on accrual, meaning that income and expenses are recorded as soon as you send invoices to customers or receive a bill.
Once a business earns above the threshold of £300,000, they will have to start using the traditional accounting method.
What information is required to record income and expenditure?
– Value of stock at the end of accounting period
– Purchase receipts of business assets
– Employee related payments
– Bank interest
– Any other income
– Year end balances
The reason traditional accounting can be more useful is that it provides a realistic and long-term view of the transactions of the business which the cash basis fails to show. However, the accrual basis requires constant monitoring as a business may be profitable under the traditional accounting method but may not have any actual cash.
If a business has an expense which continues after the financial year end, then it’s important for the business to use a proportionate basis in order to spread the cost in the period which it belongs to.
HMRC requirement of financial records
If you are a self-employed individual, its required for your business to retain records for at least five years after the January 31 deadline, whether you are using cash basis or traditional accounting, in case HMRC require any information about how your business has calculated the tax liability.
The difference between cash basis and traditional accounting
The major difference between the two methods is timing.
If the traditional accounting method is employed then your business may end up reporting income before you have received any cash payment, hence why this is the reason why some sole traders prefer cash basis. Traditional accounting can lead to your business paying tax on income, however if cash basis been used then tax have been charged the following year.
Which scheme is better for your business?
There are certain rules to be eligible to use the cash scheme, for example:
– It can only be used by small businesses such as a sole trader or partnership.
– The turnover must be less that £150,000.
As a result, cash basis accounting cannot be used by limited companies and limited liability partnerships, such as bank underwriters or businesses selling securities, therefore they have to use traditional accounting to calculate their taxable profits.
Traditional Accounting is used by larger businesses and is often used in situations where cash basis accounting has limitations, for example:
– Cash basis does not suit businesses with high level of stocks.
– Loss relief can be used through traditional accounting.
Businesses requiring finance from the bank are often questioned to show accounts showing income and expenditure which requires traditional accounting.
Overall, the question as to whether your business should use cash basis or traditional accounting depends on the size of your business, the turnover and whether the business has a limited or unlimited liability. It is common that cash basis accounting is used by small businesses whereas traditional accounting is used by larger businesses.