The arguments for and against cash basis.
The cash basis
Self-employed individuals or partnerships carrying on a small trading business will be able to choose to be taxed on the cash basis rather then being asked to do accounting adjustments designed for more complex business.
The cash basis can be used by a small self-employed business, eg sole trader or partnership individual with an income of £83,000 (150,000 from 6 April 2017) or less a year.
However, the new rules will not be available for every small business. The excluded persons are companies, limited liability partnership, Lloyd’s underwriters, a person with a section 221 ITTOIA profit averaging election or a business with a current herd basis election.
Also excluded from the cash basis are certain trades such as dealers in securities, lease premiums, managed service company, waste disposal, intermediaries treated as making employment payments, ministers of religion, pool betting, cemeteries and crematoria.
Businesses must leave the cash basis after their annual receipts exceed twice the entry threshold (from 6 April 2017 that is £300,000).
Those in favour of simplified cash accounting treatment argue that:
- Accounts preparation would be simpler as businesses will not have to make year-end accounting adjustments. They will ignore the usual adjustments for debtors, creditors or stock.
- Where a business moves from accrual to cash accounting there is likely to be a delay on tax due, as debtors and work in progress will be excluded from the taxable income. Deferral might also occur in the first year of change if the trader purchases (and pays for) a high amount of stock just before the year-end. This would be particularly relevant for a trader approaching the higher band threshold.
- At the end of the tax year the business owners won’t have to pay tax on income they haven’t yet received. In theory, this is intended to make cashflow easier.
- Interest on cash borrowings will be allowable up to £500. It would not be necessary to establish that the borrowing is financing capital employed in the business because it is not a requirement that the loan is ‘wholly and exclusively’ for business purposes.
- There is no need to make adjustments for capital allowances for plant and machinery, as capital expenditure (apart from cars) will simply be relieved as and when it is incurred, just like any other revenue expense.
- The scheme is flexible as the taxpayer has an option to switch from the cash basis to the accrual basis if their commercial circumstances change.
- Negative results (losses) under the cash basis can be carried forward and set off against future profits of the same trade.
However, those opposing the simplified cash accounting treatment argue that:
- The time spent in accounts preparation will not be significantly shorter because the time saved in not computing debtors, creditors and stock is likely to be minimal. A small business is likely to have very good credit-control procedures in place in order to remain viable, so the size of debtors and creditors is likely to be small and the amount of stock, debtors and creditors is likely to be readily available.
- Cash accounting does a good job of tracking cashflow but does a poor job of matching revenues earned with money laid out for expenses. Simple cash accounts will not give a true picture of the business performance. In order to offer credit and loans, banks might require accounts to be prepared under GAAP.
- For a new business with extensive capital requirements, the interest on borrowing may exceed the £500 limit on the amount of interest which is allowable and so cash accounting may not appeal to those traders.
- Capital allowance adjustments might still be required under cash accounting for expenditure on cars, if businesses choose not to apply the simplified expenses mileage rate.
- A choice on the amount of capital allowances claimed is not available under cash accounting and this may be detrimental to a taxpayer who makes a modest profit which is covered by their personal allowance. Such a trader is likely to prefer the option of being able to choose the amount of their claim for capital allowances in any given year, so that they can use the deduction in a more profitable later tax year.
- Because of the annual investment allowance, capital expenditure is covered by the annual investment allowance, and so full relief in the year of expenditure can be obtained in most cases (see also ACCA UK’s Guide To… Annual Investment Allowance).
- The accruals concept is not totally removed under cash accounting because rental payments for capital items (excluding hire of cars and motorcycles) are restricted to amounts paid in respect of rent relating to the accounting period and a maximum of three months after that period.
- An adjustment is also required for a capital asset used for business and private purposes and where the proportions of use changes. The reduction in business use is treated as a sale of part of the asset at current market value. This computation can create confusion and errors.
- Sideways loss relief in the year and carry back (including opening year loss relief) will not be available under cash accounting; this is an important downside for taxpayers with other sources of income (ie employment income) who can make use of trading losses in order to reduce their tax bill.
- The ability to move between cash and accrual accounting each year makes the system more complicated, increases the administrative burden and is prone to errors.
- The deferral of tax is only temporary, as the timing differences on debtors, stock and creditors will unwind in the future. Transitional rules are in place to ensure that income and expenses will be allowed once, and once only.
Article from ACCA In Practice