Cash basis vs accruals accounting for sole traders: which method should you use?

Before you can work out your profit you have to decide when each pound of income and each cost belongs to. That sounds like a dry accounting question, but the answer changes the tax you pay and the effort it takes to keep your books. UK sole traders and partnerships can use one of two methods: the cash basis, which follows your bank account, and accruals, also called traditional accounting, which follows your invoices and bills. This article explains both with examples, sets out the rules and gives you a way to choose.

What the cash basis is

Under the cash basis you record:

• Income when you actually receive the money
• Expenses when you actually pay them

It is simple, because it matches your bank statement. If you invoice a customer in March and they pay in May, the income belongs in May. If you buy supplies in March and pay in April, the cost belongs in April. You do not need to worry about money owed to you or by you at the end of the year.

What accruals accounting is

Under accruals you record:

• Income when you earn it, normally when you issue the invoice, whether or not you have been paid
• Expenses when you incur them, whether or not you have paid

At the year-end you adjust for money owed to you (debtors), money you owe (creditors), stock and prepayments. This produces a more accurate picture of the profit actually earned in the year, and it is the method companies must use.

Which is the default?

Since 6 April 2024, the cash basis is the default method for sole traders and partnerships made up solely of individuals, with no turnover limit. If you prefer accruals, you can opt out of the cash basis in your tax return. The cash basis is also the default for most individual landlords. Limited companies, limited liability partnerships and some other entities cannot use it, and some specific businesses are excluded.

A worked example

Imagine a sole trader whose year runs to 5 April.

• In March she invoices a client £4,000. The client pays on 10 April.
• In March she buys materials for £1,000 and pays on 3 April.
• Her other income and expenses for the year net to £30,000 profit.

Under the cash basis: the £4,000 is income in the next tax year, because it was received on 10 April. The £1,000 is a cost in the next tax year, because it was paid on 3 April. This year's profit is £30,000.

Under accruals: the £4,000 is income this year, because it was invoiced in March. The £1,000 is a cost this year, because it was incurred in March. This year's profit is £30,000 + £4,000 − £1,000 = £33,000.

The total over two years is the same, but the timing differs, and so does the tax in each year.

Advantages of the cash basis

• Simplicity. It follows the bank account and needs no year-end adjustments for debtors, creditors or prepayments.
• No tax on money not yet received. You do not pay tax on invoices that customers have not paid. For businesses with slow-paying customers this is a real cash flow benefit.
• Easier Making Tax Digital reporting. Quarterly updates map naturally onto bank transactions.
• Less accountancy time and cost.

Disadvantages of the cash basis

• Timing can mislead. A month with a large unpaid bill shows an inflated profit, so the figures are less useful for management.
• Restrictions on interest. Under the cash basis, the deduction for interest on loans and overdrafts is limited, with a general cap of £500 a year.
• Stock and work in progress are not tracked, so a business with large stock may find it gives a poorer picture, though purchases are deducted when paid, which can be favourable.
• Loss relief is restricted. Losses can generally be carried forward against future profits of the same trade and may not be set against other income in the same way as for accruals.
• Capital items. Under the cash basis, you can deduct most capital expenditure as it is paid, with exceptions such as cars and land and buildings, but there are limits to how this interacts with other reliefs.
• Switching has consequences. Moving between methods requires adjustments so that income and expenses are not double-counted or missed.

Advantages of accruals

• More accurate profit picture, matching income to the period it was earned.
• Better for stock-heavy and credit-heavy businesses.
• Full interest deduction, subject to the normal rules.
• Fuller loss relief options.
• A natural base for borrowing and investment, because lenders like accruals figures.

Disadvantages of accruals

• More work. You must account for debtors, creditors, stock and prepayments.
• Tax on unpaid invoices. You may pay tax on income before you have been paid, which is a cash flow strain.
• More need for professional help.

Which should you choose?

Work through these questions.

1. Do your customers pay on time? If they pay slowly, cash basis protects your cash flow.
2. Do you hold significant stock or work in progress? Accruals may give a truer picture, though the cash basis allows deduction on payment.
3. Do you borrow substantially? If interest exceeds £500 a year, accruals allows a full deduction.
4. Do you expect losses? Accruals offers wider loss relief.
5. How important is simplicity? For most small service businesses, simplicity wins.
6. Are you planning to incorporate or sell? Accruals can make the transition smoother.

Most sole traders with simple, service-based businesses are happy on the cash basis. Those with substantial debtors, loans, stock or complex losses often prefer accruals. Your accountant can model both for your business.

Changing method

If you move from the cash basis to accruals, or the reverse, you must make adjustments in the year of change. When moving to accruals, for example, income earned but not yet received and expenses incurred but unpaid must be brought in, so that nothing is missed. The adjustment is called a transition adjustment, and getting it wrong can result in income being taxed twice or not at all. Plan the change with your accountant, and keep clear records of the opening balances.

Does the method affect Making Tax Digital?

Yes, in how you prepare quarterly updates. Under the cash basis, quarterly totals come directly from bank transactions. Under accruals, they come from invoices and bills dated in the quarter. Both are supported by compatible software. See our Making Tax Digital guide and our post on how quarterly updates work.

How it affects your bookkeeping

On the cash basis, bookkeeping is mostly reconciling the bank and coding transactions, which our monthly bookkeeping service does. On accruals, bookkeeping also includes managing the sales and purchase ledgers, aged debtors and creditors, and year-end accruals and prepayments, which our year-end bookkeeping service handles. See also our guide to bookkeeping for sole traders.

Frequently asked questions

Is the cash basis the default for sole traders?

Yes, since 6 April 2024, with no turnover limit, though you can opt out.

Can a limited company use the cash basis?

No. Companies must use accruals and prepare accounts in line with accounting rules.

Will I pay less tax on the cash basis?

Not in total over time, but the timing can differ and tax on unpaid invoices is avoided.

Can I switch back and forth?

You can change, but adjustments are needed and frequent switching is not advisable.

Can you set up the right method for me?

Yes. We configure your books for either method. Get an instant quote.