Why would anyone use Cash Accounting?

As part of their Making Tax Digital initiative, HMRC have been running a consultation to get opinions about persuading small self-employed and partnership businesses to use ‘Cash Accounting’ making the argument that it’s “much easier” and you “don’t need an accountant”, etc. because all you need to do is categorise your bank transactions into the appropriate tax categories as required by your SA103 or SA800 tax form.

However, the facts are that the disadvantages in using cash accounting for your annual tax return are so great that nobody in their right mind would use it. If HMRC really want everybody to use cash accounting they need to remove all the restrictions that come with it:-

• You cannot carry losses back to previous years. So if you paid substantial tax in one year, but make a loss the next, you cannot balance out your losses against previous profits.
• You can only carry forward losses and you can only use them in the same business. So if you start a new business in another line, you lose the benefits of the losses you have carried forward.
• You cannot offset losses against other income. So if you’re in employment for a period where you are also starting up as self employed, you cannot claim tax relief for the losses in your new self-employment against the tax you pay in your employment or tax you pay on any pension you receive.

As part of their study HMRC were unable to state how many people were actually doing their accounts as if ‘cash accounting’ but submitting their self assessment as ‘accrual accounting’ (i.e. ‘not cash accounting’). The answer is of course: everybody who has any sense.

The next question is: are all these people guilty of putting false information into their self assessment tax returns? Strictly speaking the answer is ‘yes’. But it doesn’t have to be so, because it is very easy to convert your cash basis accounting figures to standard (accrual) accounting.

Cash Accounting to Standard Accounting Conversion System

Allowing our customers to use ‘cash accounting’ in their accounts software makes it much easier for them to use: all that is required is for them to categorise the transactions on their bank statements.

However, it is still very important that we submit their annual accounts as ‘standard accounting’ so that they get the benefits of claiming for capital expenditure and being able to carry profits and losses forwards, backwards and sideways.

This is done by applying a simple set of corrections that change the figures from ‘cash accounting’ to ‘standard accounting’ for any period such as a year. As follows:-

Get the cash accounting figures for sales and purchases within the period, then …

• Subtract the value of sales receipts received within the period for the sales invoices issued before the period started.
• Add the value of sales invoices issued within the period that remained unreceived at the end of the period.
• Subtract the value of purchase payments paid within the period for purchase orders issued before the period started.
• Add the value of purchase orders issued within the period that remained unpaid at the end of the period.

If you are certain that all outstanding invoices were received and that all outstanding purchase orders were paid within the period, then a simpler method can used:-

Get the cash accounting figures for sales and purchases within the period, then …

• Add the change in the value of the sales ledger, from the start of the period to the end, to the cash accounting sales figure.
• Add the change in the value of the purchase ledger, from the start of the period to the end, to the cash accounting purchases figure.

The key component in the above conversions is having a note of the values of the sales ledger and purchases ledger at the start of each period. i.e. Make a note of how much your customers owe you, and how much you owe your suppliers, at the start of each year. It is that simple.

Why do your accounts as ‘cash’ at the time and later convert them to ‘standard’.

Most of the people who use accounts software such as Sage, Xero, Quickbooks, etc. are using systems that are ‘hard-wired’ for standard accounting, and if they are able to use these systems perfectly, as intended, then there will be no errors. However many users, if not most, have trouble in matching up sales invoices in the sales section with sales receipts in their bank transactions. (And similarly, in matching purchase orders to purchase payments.)

So if money goes into your bank account, and for whatever reason, you cannot match it to a specific invoice, it counts as a ‘Cash Sale’ and you end up paying tax twice: once on the invoice you issued and again on the money you received: you were unable to match the invoice to the payment, and the system does not spot that they are one and the same.

A few unmatched sales receipts soon adds up, but the biggest problem is that most users are not actually aware of the errors building up, and pay the tax regardless; often much more that they should be paying. The cause of this can be as simple as:-

• Customers who do not put your reference number on their payments
• Customers who pay the wrong amount by mistake
• Customers who get somebody with a different name to make their payments
• Customers who pay more than one invoice but use only one reference number (or none)
• Customers who do any of the above in any combination

With regard to all the possible errors that can happen, the end of year conversion system is ‘bullet proof’ and guarantees that you will be paying no more tax or VAT than is due.