How do I prepare my accounts?
Sole traders and partnerships prepare their business accounts and calculate their taxable profits by using one of two methods – the cash basis or the accruals basis. This page explains how unincorporated businesses should record their business income and expenditure using these methods in order to calculate their profits for their Self Assessment tax return.
For most small businesses there are two alternative methods of calculating your self-employment profits, the accruals basis and the cash basis. You can navigate this page by using the quick links above.
The accruals basis, which is also called the traditional accounting or the GAAP ‘Generally Accepted Accounting Principles’ basis, uses basic accountancy principles to ensure that only receipts and expenses which apply to the accountancy year are recorded in that year.
For example, if a furniture shop buys nine beds to sell and at its year-end there are three beds left then under the accruals basis only six beds would be treated as a purchase during the year, with the remaining three beds being treated as a stock asset for the following year.
Another example: Julie runs a delivery service business and has a year-end of 5 April. When Julie insures her delivery van the period of insurance is from 1 April 2020 to 31 March 2021 and the insurance payment is withdrawn from her bank account on the 4 April 2020. If Julie chooses to use the accruals basis on her Self Assessment tax return then the vast majority of the insurance payment will fall into the 2020/21 tax year as a prepayment because most of the insurance period relates to the 2020/21 tax year.
If you want to use the accruals basis then no election is required on your Self Assessment return.
The cash basis was designed to make accounting and completing a Self Assessment tax return easier for small unincorporated businesses, that is sole traders and partnerships.
The cash basis allows businesses to account for their income and expenses when they actually receive payment or when they actually pay for an expense. By using the cash basis you will not need to calculate debtors and creditors at the year-end, nor perform a stock-take or estimate accruals and prepayments.
Using the same examples of the furniture shop and Julie’s delivery van illustrating the accruals basis (see above), the examples below show how the cash basis would work.
For example, if a furniture shop buys nine beds to sell and at its year-end there are three beds left then under the cash basis the cost of all nine beds would be treated as a purchase during the year as long as the beds had been paid for during the same tax-year. There would be no stock asset at the year-end.
Another example: Julie runs a delivery service business and has a year-end of 5 April. When Julie insures her delivery van the period of insurance is from 1 April 2020-31 March 2021 and the insurance payment is withdrawn from her bank account on the 4 April 2020. If Julie elects to use the cash basis on her Self Assessment tax return then the full expense of the insurance payment will fall into the 2019/20 tax year because the payment was made during the 2019/20 tax year. There will be no insurance prepayment and no accounting adjustment to be made in the 2020/21 tax year.
Most sole traders and partnerships with annual sales or turnover of less than £150,000 can elect on their Self Assessment tax return to use the cash basis.
For universal credit (UC) claimants the entry threshold is double, at £300,000.
You must leave the cash basis the year after your turnover is higher than the exit threshold which is £300,000.
If you have more than one business and you elect to use the cash basis for one of your businesses then you must also use the cash basis for all your other businesses. The total of the turnover of all your businesses is used when looking at the entry and exit levels of the cash basis.
There are certain businesses that are not allowed to use the cash basis: these include partnerships where at least one of the partners is not an individual and self-employed people using the profit-averaging election. A complete list of the businesses that cannot use the cash basis can be found in the more detailed information section.
You must choose to use the cash basis as it is not a default option. If you want to use the cash basis then you must elect to do so by ticking the relevant cash basis box on the Self Assessment tax return. This is box 8 on the short self-employment pages of the tax return or box 10 on the full self-employment pages.
How do I account for income and expenses under the cash basis?
Under the cash basis, income is recorded when it is actually received; this may be a different date to the sales invoice.
Expenses are recorded when they are actually paid; this may be a different date to when the expense is made, for example when stock is delivered or a purchase invoice is received.
There are no strict rules of when income receipts or expense payments should be recognised by a business using the cash basis; however a business must use a consistent approach.
For example, a business must decide what date to use when receiving payments by cheque; is it when the cheque is received from the customer? Or when it is paid into the bank? Or when it is shown on the bank account but cannot be drawn against? Or when the cheque has cleared? So if a business decides to record income only after cheques have been cleared then that approach must be used consistently for all cheque receipts.
What business records do I need to keep under the cash basis?
Although HMRC expect businesses using the cash basis to have more simplified accounting than under the accruals basis, a business will still be expected to keep the proper business records required to complete an accurate Self Assessment tax return.
A business using the cash basis should still need to keep a record of its debtors, creditors and stock so that the business can work effectively.
Under the cash basis, bank and loan interest costs and financing costs, which include bank loan arrangement fees, are allowed up to an annual amount of £500.
If the business has interest and finance costs of less than £500 then the split between business costs and any personal interest charges does not have to be calculated.
Businesses should consider their annual business interest costs and if it is anticipated that these costs will be more than £500 it may be more appropriate for the business to use the accruals basis and obtain tax relief for all the business-related financing costs.
Hire Purchase interest is not included in the annual amount of £500 and can be treated as a separate expense.
What happens if I buy capital equipment?
Most capital equipment can be treated as an expense under the cash basis, but this does not include land, buildings, cars and motorcycles (capital allowances can usually be claimed on cars and motorcycles). This means that capital allowances on eligible capital equipment do not need to be calculated.
Any vehicles (apart from cars and motorcycles) purchased when using the cash basis must stay in the cash basis even if the business then switches to use the accruals basis.
Under the cash basis, any trade losses can be carried forward to be utilised against business profits in the future. It is not possible to carry losses back to be used against profits made in the previous year or to use losses against other income earned during the same tax year (known as sideways loss relief).
If your business has made losses then it may not be appropriate to use the cash basis as there are more ways to utilise losses by using the accruals basis.
What happens if I take business stock for personal use?
Sometimes small business owners take stock to use personally: if the business is using the cash basis then the stock can be accounted for at cost price.
Under the accruals basis, the principles set out in the Sharkey and Wernher case stipulate that any stock taken for personal use must be accounted for at market value at that time, although sometimes this can be complicated to calculate.
What happens if my business is VAT registered?
If your business is VAT registered but has sales under the cash basis entry threshold you are allowed to elect to use the cash basis.
If you are self-employed and claiming universal credit (UC) you can enter the cash basis if your turnover is less than £300,000 for the 2020/21 tax year.
If you are self-employed and will be claiming UC when it replaces existing benefits such as working tax credit then you will need to report your business income and expenses on a monthly basis. Unfortunately the universal credit cash accounting will differ from the Self Assessment optional cash basis.
There are transitional rules when changing from the accruals basis to the cash basis. These are to ensure that overall taxable profits are correct by taxing income and deducting all expense payments only once.
The process of steps you will need to take to move from the accruals basis to the cash basis is made during the first year of using the cash basis. See the more detailed information section on the transitional rules.
If you elect to use the cash basis then you must continue to use it until either:
- your turnover increases above the exit threshold of £300,000; or
- there are commercial reasons for leaving the cash basis, these include having financing costs of over £500 per annum or wanting to use sideways loss relief.
The following illustration shows when it may be appropriate to change from the cash basis for commercial reasons. Alison’s business used the cash basis in the tax year 2019/20, but during the tax year 2020/21 Alison has taken out a new business loan – the loan arrangement fee was £250 and the annual interest charge will be £400. Under the cash basis, Alison will only receive tax relief of £500 for the interest and loan arrangement fee even though the actual cost to her business was £650. By leaving the cash basis in 2020/21 Alison will be able to deduct all of the £650 as a business financing expense under the accruals basis.
Upon exiting the cash basis you will have to use the accruals basis unless your turnover becomes lower than £150,000 in which case you can choose to elect to use the cash basis again if you want to.
If you leave the cash basis then there are transitional rules when changing to the accruals basis. These rules are to ensure that overall taxable profits are correct by taxing income and deducting all expense payments only once.
The process of steps you will need to take to move from the cash basis to the accruals basis is made during the first year of using the accruals basis but the tax adjustment is spread over six years. However, this six-year period can be shortened if you prefer. See the more detailed information section on the transitional rules and the spreading adjustment.
Our guide to self-employment is intended to supplement the material in this section. We wrote this guide to help advisers (non-tax) who advise low-income self-employed individuals and also for self-employed people who want more detailed information in one accessible place. The guide explains the less common tax rules and contains more detailed information including a case study showing how to prepare accounts and what to include on your tax return when using the cash basis.
Who can use the cash basis?
The following businesses cannot use the cash basis and must use the accruals basis:
- those using the Herd basis;
- self-employed people using the profit averaging election;
- limited liability partnerships (LLPs);
- partnerships unless all the partners are individuals;
- those which have claimed business premises renovation allowance;
- those in the mineral extracting trade;
- Lloyd’s underwriters;
- businesses which have claimed the Research & Development allowance;
- dealers in securities;
- those dealing in lease premiums;
- Ministers of religion;
- those claiming tax relief for mineral royalties;
- pool betting duty businesses;
- intermediaries treated as making employment payments;
- businesses dealing in waste disposals;
- cemeteries and crematoria businesses.
The transitional rules for changing from the accruals basis to the cash basis are explained below:
- For example, Brian uses the accruals basis for the tax year 2019/20 and at the end of the tax year he has sales income of £20,000 which includes £1,000 that has yet to be paid. When Brian prepares his accounts in order to complete his 2019/20 Self Assessment tax return, he includes his turnover (sales) as £20,000 and records debtors of £1,000. In 2020/21 Brian decides to use the cash basis and in May 2020 he receives payment for £1,000 for the income included in the 2019/20 tax return.
Under the cash basis, Brian would account for the £1,000 when he receives it, but as Brian is moving from using the accruals basis to the cash basis this would result in £1,000 being taxed twice, both in 2019/20 and 2020/21. Therefore, there is a transitional adjustment to the cash basis income in 2020/21 to reduce sales income by £1,000.
Any expenses purchased using the accruals basis but not paid for until using the cash basis should be disregarded as expenses under the cash basis because tax relief has already been allowed.
Following on from the example above, Brian, who switches from using the accruals basis in 2019/20 to using the cash basis in 2020/21, purchases tools to use in his business in March 2020. Brian pays £300 for the tools in May 2020.
As Brian is using the accruals basis when he prepares his accounts and Self Assessment tax return for 2019/20, he will include the purchase of tools in March 2020 as a business expense.
The following tax year, when Brian is using the cash basis, he should account for all expenses when he actually pays for them and as he paid for the tools in May 2020 this would usually be treated as an expense in the 2020/21 tax year. However, Brian has already received tax relief for the tools in 2019/20 therefore the expense of £300 is ignored in 2020/21, and the total expenses for this year are reduced by £300 as part of these transitional adjustments.
Under the accruals basis any closing stock held by the businesses at its year end should have not been deducted as an expense but treated as an asset. When joining the cash basis the stock is deducted as a purchase expense.
Continuing the example of Brian’s garden furniture business; at the end of 2019/20 Brian has closing stock of four chairs which he paid £200 for in February 2020. Under the accruals basis, this closing stock would be treated as an asset and not an expense, so Brian would have not yet received any tax relief for the £200.
When Brian switches to the cash basis, he will make an adjustment to treat the closing stock as a purchase expense and will increase his expenses by £200 in 2019/20.
- Some capital assets (except for cars, motorcycles, land and buildings), which have qualified for capital allowances under the accruals basis will still have a tax value left in their capital allowances pool (this means they have not received capital allowances up to their full cost value yet). When the business moves to the cash basis, any amounts which still haven’t received full capital allowances are treated as a cash purchase upon joining the cash basis.
For example, Brian has previously claimed capital allowances on machinery but at the end of the 2019/20 tax year the balance on the general capital allowance pool is £1,500. When Brian elects to use the cash basis in 2020/21 he will be able to treat the £1,500 as an expense in the 2020/21 tax year and no longer claim capital allowances.
The transitional rules for changing from the cash basis to the accruals basis are listed below:
- Any sales made under the cash basis where payment was received after moving to the accruals basis must be included as income under the accruals basis tax year otherwise this income will not be taxed.
For example, Alison runs a small business and elected to use the cash basis, however her annual financing costs were higher than £500 so she decides to move in the 2020/21 tax year from the cash basis to the accruals basis instead.
During March 2020 when Alison was using the cash basis, she made sales of £1,000 but at the year-end only £600 of these sales had been paid for and the business had debtors of £400. When Alison prepared her tax return under the cash basis for 2019/20 she only includes £600 of the March sales which was the income she actually received. During the next tax year (2020/21), Alison receives payment for the remaining £400 debt in May 2020. Under the transitional rules, Alison needs to account for the £400 income in 2020/21 even though she is now using the accruals rules because otherwise this income would not be taxed. Therefore, Alison needs to increase her sales income in 2020/21 by £400.
- Any expenses incurred under the cash basis but not actually paid for until the business was using the accruals basis, must be deducted under the accruals basis.
Following on from the example above, Alison purchased some clothes to sell in her shop in March 2020 when Alison was preparing her Self Assessment tax return using the cash basis. However, Alison only paid for this stock in June 2020 when she was using the accruals basis. Alison would not have included the stock as an expense during the 2019/20 tax year as she did not pay for the stock until the following tax year. Therefore, an adjustment must be made under the transitional rules to include this stock as an additional expense in the 2020/21 tax year.
- Capital expenditure will normally be treated as an expense under the cash basis and upon moving to the accruals basis will be treated as a capital allowance asset with no capital allowances left to claim.
The exception to this rule will be when an asset has been bought on hire purchase as only the cash payments made will be treated as an expense under the cash basis. After moving to the accruals basis, the remainder of the cost of the asset will either be treated as unrelieved expenditure in the general pool or be fully written down using the annual investment allowance (as explained on GOV.UK).
For example, Alison has purchased a new till under hire purchase, which has a capital cost, excluding interest charges, of £1,500 and under the cash basis she has made payments of £400 towards the capital cost of the till. When Alison moves from the cash basis to the accruals basis, she will be able to treat the till as an asset qualifying for capital allowances and will include £1,100 (£1,500 less £400) as a general pool asset and claim capital allowances or claim the annual investment allowance for £1,100.
The spreading adjustment
When leaving the cash basis, any additional income arising from the move to the accruals basis will be spread over six years and taxed 1/6th in each year. Using the examples above, if Alison calculates that she will increase her income by £600 by moving from the cash basis to the accruals basis in 2020/21 then this adjustment income would be taxed equally over six years, so there would be £100 additional income for each tax year from 2020/21 to 2025/26.
If you do not want to spread the adjustment income over six years you can elect to accelerate the charge and decide how much you want it to be each tax year.
For example, Alison decides to use the spreading adjustment and so for the 2020/21 tax year only £100 of the adjustment income is taxed. However, the following year Alison decides she wants to pay tax on the income as soon as possible so she elects to treat the remaining adjusted income as falling in the 2021/22 tax year which increases her income by £500 and no further spreading adjustment is made in later years.
Alison must make an election to accelerate the spreading adjustment within one year of the Self Assessment tax return filing deadline. So, in the case of the above example, Alison must make her election by 31 January 2024 (one year after the 2021/22 filing deadline).
|◀ Work out taxable profits|