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The Benefits and Drawbacks of
Using the Cash Basis

Simpler accounting for small businesses?

THE GOVERNMENT is proposing to introduce a new voluntary cash basis accounting method for small businesses from April 2013. They claim it will make accounting simpler for small businesses and reduce a great deal of the administrative burden on them.

There have been lots of changes to the cash basis since this article was published. The latest information is contained in our
Small Business Tax Planning Guide

Personally, I have my doubts and, although the scheme is meant to be voluntary, there are signs that it could represent the ‘thin end of the wedge’ and may herald a move towards a more aggressive approach to the taxation of small businesses, with far less recognition of the unique and special nature of each business and its owner in the future.

The Government is promoting the new accounting method on the basis of its ‘simplicity’ but, in my view, it will still leave many small businesses facing most of the same complexities that they face now, will probably add a few more, and will leave many small business owners worse off!

Perhaps worst of all, this ‘simple’ new method denies many of the most important deductions currently available, including interest relief for many business borrowings. This will act as a major disincentive to any small business seeking to grow. How does that fit in with the Government’s enterprise agenda?

A Simple Idea?
The basic idea is simple enough. Under the cash basis, income is recognised, and will be taxable, when it is received, and expenditure will be deductible when it is paid. So, in effect, the theory is that there will be no need to worry about debtors, creditors, accruals, prepayments, or stock valuations.

The additional benefit (in theory) is that expenditure on equipment, machinery, and most other items will be allowed when it is paid, with no need to distinguish between ‘revenue’ and ‘capital’ expenditure.

All these things are just a matter of timing, so the idea is that the business will be no better or worse off in the end, even though the amount of profit which is taxed in any given year may change.

But timing is SO important! Most business owners are much more concerned about how much tax they will have to pay this year than whether they are going to pay the same amount of tax between now and when they sell up!

The First Red Herring
The Government proposes to make the cash basis available to sole traders and partnerships with annual sales not exceeding the VAT registration threshold (currently £77,000). It will not be available to companies, Limited Liability Partnerships, other partnerships which are not composed entirely of individuals, or property businesses (i.e. landlords).

So, the first ‘red herring’ to highlight is the so-called ‘benefit’ of not needing to distinguish between ‘revenue’ and ‘capital’ expenditure. Most businesses can claim an immediate 100% deduction on up to £25,000 of qualifying capital expenditure each year anyway (the annual investment allowance): so there won’t be many with sales of less than £77,000 who are spending enough to worry about that one!

For Better or Worse?
To assess whether the cash basis might be beneficial for your business, the first step is to consider what the impact on the timing of your business profits is likely to be. In other words, will profits generally be accelerated and taxed earlier, or will they generally be deferred and taxed later?

Under the cash basis, you will not be taxed on your debtors – sales you have made but not yet been paid for. You will also be able to claim a full deduction for any expenses that you have paid for in the year, without any adjustments for closing stock or prepayments.

However, you will not be able to claim a deduction for business creditors – purchases you have made but not yet paid for; or accruals – expenses that relate to the period of trading but which will arise later.

Rosie opens a new shop on 6th April 2013. In the year to 5th April 2014, she takes £60,000 in sales and makes the following expense payments:

Rent: £13,000
Electricity: £2,000
Equipment: £4,000
Insurance: £2,000
Stock purchases: £20,000

If Rosie uses the new cash basis, she will therefore have a ‘profit’ for tax purposes of £19,000.

Under normal accounting methods, however, Rosie would have a few adjustments to make. Firstly, she would not claim her equipment purchases as an expense but would instead claim capital allowances of the same amount – hence the ‘red herring’ referred to above, as there is no overall effect on her taxable profits.

Next, Rosie would need to reduce her expense claims to take account of:

Prepaid rent for 6th to 30th April 2014 - £833
Prepaid insurance relating to period post-5th April 2014 - £500
Stock on hand at 5th April 2014 - £4,000

However, she would also increase her expense claims for:

Unpaid electricity bill - £500
Trade creditors (goods purchased not yet paid for) - £6,000
Accountancy fee accrual - £1,500

Finally, she would also reduce her sales to take account of goods returned after 5th April 2014, £333.

These adjustments would reduce her overall taxable profit to £16,000, saving her at least £870 in tax and national insurance.

As we can see, Rosie would be worse off under the cash basis in her first year of trading since she would be taxed on a higher business profit.

I am not for a second suggesting that this would always be the case. It happened in Rosie’s case mainly because her:

Were greater than her:

And this is the comparison which every business needs to make in order to initially determine whether cash accounting might be beneficial for them.

In short, it will generally come down to a question of whether debtors and stock (current assets) tend to be greater than creditors and accruals (current liabilities).

At this stage, it is worth pointing out that this is often where a good accountant proves their worth, by making the adjustments which correctly reflect all of the true costs of the trading period, thus reducing the value of current assets and making sure that all of the relevant liabilities are taken into account. This, in turn, brings the trading profits down to the correct level – but the scope to do this will be lost under the cash accounting method!

Nonetheless, even after all of these adjustments, there will be some businesses where the comparison made above will go the opposite way to Rosie’s and these businesses might benefit from cash accounting – but only ‘might’: because there are a few additional problems to be considered!

Cash Basis Restrictions
Any business adopting the cash basis will be unable to claim interest on cash borrowings (business loans and overdrafts) and other associated costs such as loan arrangement fees. Other interest costs, such as hire purchase interest, mortgage interest on business premises, and credit card interest on purchases of business assets will generally be allowable.

Well that’s simple isn’t it? Buy a piece of equipment on HP and you get the interest allowed; take out a bank loan to buy it and you’re denied any relief for the interest. Really simple, yeah!

Businesses using cash accounting will also be compulsorily forced to use fixed flat rate allowances in respect of business use of cars, motorcycles, or the proprietor’s home (see Box). Fixed rate allowances for vans will also be available but will be optional.

Where the flat rate allowances apply, there can be no claim for any actual costs arising in connection with the relevant property or motor vehicle, including finance costs and capital allowances on purchase costs.

The use of flat rate allowances for the proprietor’s car and home takes away a great deal of flexibility and makes no allowance for personal circumstances where the actual costs arising may be considerably greater than those proposed by the Government.

Example Part 2
Rosie took out a five-year loan of £20,000 to get her business started. She paid a loan arrangement fee of £500. She also has a business overdraft facility of £5,000 for which she paid a fee of £90. During the year to 5th April 2014, she incurred £300 in interest on her overdraft and £1,200 on her loan.

She bought a car for £10,000 in May 2013. She drove a total of 12,000 miles to 5th April 2014, of which 9,000 were on business. Her running costs for the car total £4,000.

Rosie uses one room in her house to store surplus stock and another to carry out her business administration, book-keeping, etc. There are five rooms in her house excluding bathroom, kitchen and hallways and her total household running costs for the year to 5th April 2014 amount to £5,000. She estimates that the two rooms used for business purposes each have about 75% business use.

Under normal accounting rules, Rosie may claim the following deductions for these items:

Loan arrangement fee (1/5th): £100
Overdraft fee: £90
Interest (£300 + £1,200): £1,500
- Capital allowances (18%) x 9,000/12,000: £1,350
- Running costs (£4,000 x 9,000/12,000): £3,000
Use of home (£5,000 x 2/5 x 75%): £1,500

These reduce her taxable profit for the year to 5th April 2014 to just £8,460.

Under the cash accounting method, the only item she can claim is a mileage allowance of £4,050 (9,000 miles at 45p/mile). This leaves her with a taxable profit of £14,950 (£19,000 - £4,050), which is £6,490 more than under normal accounting principles. This would probably cost her at least £1,882 in additional tax and national insurance and, this time, the differences arising are not just a matter of timing.

More Red Herrings
Let’s dispel a few more ‘simplification’ myths, shall we?

Under the cash basis, a business proprietor will still need to keep a mileage log if they wish to claim any allowances for use of a car or motorcycle. Additionally, however, if they wish to claim for business use of their home, they will need a record of how many hours of ‘core’ business activities take place there.

They will still need to record all business income and expenditure, albeit on a cash basis, and despite not having to worry about capital allowances calculations, they will still only be able to claim expenditure on items of equipment, machinery, furniture, etc, which would have qualified for capital allowances under normal principles. Private use adjustments will also still be required, where relevant.

In my experience, the hardest part of preparing accounts for most small business owners is not deciding when something can be claimed, but whether it can be claimed. It takes the average business owner moments to understand the idea of when income is earned and when expenses are incurred, but it has taken me most of my adult life to understand all the nuances of which expenses are allowable for tax purposes.

Cash accounting takes away only the trivial complexities of timing and leaves most of the other problems in place whilst also denying many perfectly legitimate deductions such as bank interest and many ‘use of home’ claims.

And, worst of all, when the business owner needs a set of accounts for anything else: a bank loan, student grant application for their children, potential business sale, or just to understand whether their business is really making a profit, they will still have to produce proper accounts anyway. In fact, under current proposals, the cash accounting method used for tax purposes cannot even be used for Universal Credit claims. Bizarre!

More Cash Accounting Drawbacks

‘Negative’ results (i.e. losses) arising under the cash basis will only be available to carry forward for relief against future profits from the same trade. This means that business owners cannot claim relief for trading losses against other income arising in the same year or the previous one. New business owners will also be denied the opportunity to carry losses back for relief against other income in the previous three years.

Accounting periods ending on 5th April will be compulsory under cash accounting. Any existing business wishing to enter the cash accounting method will have to prepare accounts to 5th April for the previous period: leading to a considerable increase in taxable profits for that period in many cases.

Under current proposals, businesses may exit the cash accounting method and return to normal accounting, either voluntarily at any time, or compulsorily, when sales income exceeds £150,000 per year. If they do, however, they will have to continue using the compulsory fixed rate allowances for cars and motorcycles. They will also need to continue using the optional fixed rate allowance for vans if they have previously chosen to use it.

This is particularly worrying since the Government has floated the idea of making the cash accounting method the ‘default’ position for all new businesses unless they choose to opt out of it.

Without proper advice, therefore, any new business starting up in the future may simply drift into a situation where they are unable to claim a proper deduction for motor expenses and will also be denied early years’ loss relief. In effect, they will be walking into a trap!

In time, it is not beyond the realms of probability to foresee the Government forcing all small business owners to adopt this ‘default’ position in order to restrict claims for use of cars, motorcycles and their own home to the levels proposed under the cash basis and deny them loss relief and interest relief.