Cash basis accounting records income when money is actually received and expenses when money is actually paid out. Unlike accrual accounting, there is no need to track invoices issued but unpaid or expenses incurred but not yet settled. The method is simpler and is designed for smaller unincorporated businesses in the UK.
Section 1: How Cash Basis Works
Under the cash basis, the timing of the cash movement determines when a transaction is recorded:
- Income is recorded on the date the money enters the business bank account or is received as cash
- Expenses are recorded on the date the money leaves the business bank account or is paid as cash
1.1 A Simple Example
A freelance graphic designer invoices a client £2,000 on 15 March. The client pays on 10 April. Under cash basis accounting, the £2,000 is recorded as income in April when the cash is received, not in March when the invoice was issued.
Similarly, if the designer pays £500 for software on 25 March but the subscription covers April to June, the full £500 expense is recorded in March when the payment is made.
1.2 No Accruals or Prepayments
One of the main simplifications of cash basis is that there are no accruals or prepayments. There is no need to estimate amounts owed at the end of a period or spread costs over multiple months. This significantly reduces the bookkeeping burden.
Section 2: Who Can Use Cash Basis in the UK?
2.1 HMRC Eligibility
Since the 2024–25 tax year, the cash basis has been the default for eligible self-employed individuals and partnerships unless they opt to use traditional accounting. The same reform removed the former turnover entry and exit thresholds, the cap on interest deductions and most of the restrictions on loss relief. Some businesses remain excluded, so eligibility depends on the business type rather than turnover.
The cash basis is available for:
- Sole traders
- Ordinary partnerships (not limited liability partnerships)
- Landlords with property income
2.2 Who Cannot Use Cash Basis
The following are excluded from using the cash basis:
- Limited companies (must use accrual accounting under the Companies Act 2006)
- Limited liability partnerships (LLPs)
- Companies already using IFRS or FRS 102
If a business is a limited company, it must use accrual accounting and produce a full set of financial statements including a balance sheet.
Section 3: Tax Implications
3.1 Income Tax
Under the cash basis, taxable profit is simply:
Cash received minus cash paid = taxable profit
This can benefit businesses where there is a significant gap between invoicing and receiving payment, because tax is not due on income that has not yet been collected.
3.2 Restrictions on Deductions
A few items are treated differently under the cash basis:
| Expense type | Cash basis treatment |
|---|---|
| Interest and finance costs | Deductible on the same principles as under accruals |
| Capital expenditure | Most items deductible when paid (no separate capital allowances needed) |
| Car purchases | Only capital allowances, not cash basis deduction |
| Losses | The same reliefs as under accruals, including set-off against other income |
3.3 Capital Expenditure
Under the cash basis, most capital purchases are deductible in full when paid, rather than being depreciated over several years. This is a significant simplification. However, cars are excluded and must use HMRC’s capital allowance rules.
3.4 VAT
The cash basis for income tax is separate from the VAT cash accounting scheme. A business can use one without the other. Under the VAT cash accounting scheme, VAT is accounted for when payment is received or made, rather than when invoices are issued.
Section 4: Advantages of Cash Basis
- Simplicity: Far less bookkeeping than accrual accounting; no adjusting entries, no accruals, no prepayments
- Cash flow clarity: The accounts directly reflect how much cash has come in and gone out
- Tax timing: Tax is only paid on money actually received, reducing cash flow pressure
- Lower costs: Less accounting expertise required, potentially reducing professional fees
- Immediate capital deductions: Most capital purchases are deducted in full when paid
Section 5: Limitations of Cash Basis
5.1 Incomplete Financial Picture
Cash basis does not produce a balance sheet, so there is no clear picture of:
- What customers owe the business (receivables)
- What the business owes suppliers (payables)
- The value of assets owned
- The business’s overall financial position
5.2 Not Always Suitable for Growing Businesses
As a business grows, the cash basis becomes less useful:
- Investors and lenders typically require accrual-based accounts
- Management needs more detailed financial information for decision-making
- Financial ratios and working capital analysis require accrual data
5.3 Distorted Profit Picture
Large one-off payments or receipts can distort the profit in any given period. A business that receives a large advance payment shows inflated income, while one that makes a large purchase shows deflated profit, even though neither event reflects the true underlying performance.
Section 6: Cash Basis vs Accrual Accounting
| Feature | Cash basis | Accrual accounting |
|---|---|---|
| Revenue recorded | When received | When earned |
| Expenses recorded | When paid | When incurred |
| Accruals and prepayments | No | Yes |
| Balance sheet required | No | Yes |
| Suitable for limited companies | No | Yes |
| Default for sole traders and partnerships | Yes | Only by election |
| Complexity | Low | Higher |
For a full explanation of accrual accounting and why most UK businesses use it, see our article on accrual accounting.
Section 7: Transitioning Between Methods
7.1 Moving to Cash Basis
A business that meets the eligibility criteria can elect to use the cash basis on its self-assessment tax return. Transitional adjustments may be needed to prevent income or expenses being taxed twice or not at all.
7.2 Moving Away from Cash Basis
If a business opts out of the cash basis or incorporates and must use accrual accounting, adjustments are needed:
- Outstanding invoices at the transition date must be brought into the accrual accounts
- Prepayments need to be identified and recorded
- Asset values need to be established for the balance sheet
7.3 Practical Considerations
Before choosing the cash basis, consider:
- Whether the business is likely to incorporate or need a balance sheet
- Whether lenders or investors will require accrual-based accounts
- Whether the simpler record-keeping genuinely saves time and cost
Section 8: Record-Keeping Under Cash Basis
Even with the simpler cash basis, HMRC requires businesses to keep records of:
- All money received and the source
- All money paid out and the purpose
- Any amounts personally invested or withdrawn by the business owner
Records must be kept for at least five years after the 31 January filing deadline for the relevant tax year. Digital records are acceptable and encouraged under HMRC’s Making Tax Digital programme.
Good record-keeping supports accurate tax returns and makes it straightforward to answer any questions from HMRC during a compliance check. Understanding the fundamentals of bookkeeping remains important even under the cash basis.