What is cash accounting?

How does cash accounting work in practice?

Under the traditional accruals basis, a sale counts when you invoice it and a cost counts when you receive the bill. Under cash accounting, neither counts until the money moves. An invoice unpaid at the year end is not income yet; a bill unpaid at the year end is not a cost yet.

The appeal is simplicity and cash-flow. You are never taxed on money you have not received, and you never fund VAT on invoices your customers have not paid. The cost is a less accurate picture: profit lurches with the timing of payments rather than the timing of work.

Two separate things share the name. The cash basis is a method for working out taxable profit, used by sole traders and partnerships. The VAT cash accounting scheme is a way of accounting for VAT on money received and paid. You can use either, both, or neither.

A worked example

A freelance consultant invoices a client £4,000 on 20 March. The client pays on 15 April. Her tax year ends on 5 April.

On the cash basis, the £4,000 is income of the following tax year, because that is when it arrived. On the accruals basis it belongs to the year just ended, because that is when the work was invoiced. Same money, different year, and potentially a different tax bill depending on her other income in each.

If she is also on the VAT cash accounting scheme, the VAT on that invoice is due on the return covering 15 April, not the one covering 20 March. Had the client never paid, no VAT would ever have been due — which is why the scheme suits anyone with slow payers.

Who can use it?

• —The cash basis is now the default for sole traders and partnerships working out profit for Self Assessment; you can opt for the accruals basis instead if you prefer.
• —Limited companies cannot use the cash basis for corporation tax. Their accounts and tax must follow the accruals basis.
• —The VAT cash accounting scheme is open to any VAT-registered business under a turnover limit set on gov.uk, including companies.
• —Neither removes the need to keep records of unpaid invoices. You still need to know who owes you what.