Cash Basis vs Accrual Accounting for Small Businesses
Cash basis and accrual accounting are two fundamentally different ways small businesses record income and expenses. If you're choosing between them — or wondering why your accountant insists on one over the other — the answer comes down to timing: when you record money matters more than you'd think, and it can affect your tax bill, your apparent profit, and HMRC's view of your accounts.
Here's the key difference in 30 seconds: cash basis accounting records income when money arrives and expenses when you pay them. Accrual accounting records both when they're incurred, regardless of payment timing. For UK small businesses, this choice isn't just about preference — HMRC rules, turnover thresholds, and your cash flow situation all constrain it. Let's work through both methods with real numbers so you can see which suits your business.
What Is Cash Basis Accounting?
Under cash basis accounting, you only record transactions when cash moves. An invoice for £500 doesn't count as income until the customer pays you. A supplier bill for £200 doesn't count as an expense until you write the cheque.
Example: Freelancer on cash basis
You're a freelancer. In January, you invoiced three clients for £1,000 each (£3,000 total). By 31 January, only one client has paid. Your profit on cash basis is £1,000, not £3,000, because the other two invoices haven't been settled.
In February, that client who owed you £2,000 finally pays. Now your February profit jumps to £2,000 on cash basis — even though you didn't do any new work. Your monthly profit figures swing wildly depending on when invoices arrive, not when you earned them.
This is exactly what cash basis accounting reflects: cash in, cash out, nothing in between.
Advantages:
- Matches your bank account. Your profit on paper mirrors your actual cash.
- Simpler to administer. No accruals, prepayments, or complex adjustments.
- Lower apparent profit in early years if you're owed money. That can mean a lower tax bill, which is why some businesses like it.
- Easier for sole traders and very small businesses with simple finances.
Disadvantages:
- Gives a distorted picture of profitability. Invoices and bills out of sync mean your "profit" doesn't reflect the actual performance of your business.
- Seasonal businesses can show wildly different profits month to month even if underlying performance is stable.
- Doesn't suit businesses with long payment terms (construction, wholesale, etc.).
What Is Accrual Accounting?
Under accrual accounting, you record income when you've earned it and expenses when you've incurred them, regardless of when payment happens.
Example: Same freelancer on accrual basis
Same scenario: three £1,000 invoices in January, but only one paid. On accrual basis, your profit for January is £3,000 (the value of work completed), minus any actual expenses you've paid or owe. The fact that two invoices haven't been paid doesn't reduce your profit figure — it's recorded as money owed to you (an asset called receivables).
In February, when those invoices get paid, your profit doesn't change — you already counted the income in January. February shows much smaller profit because you haven't done as much new work.
This gives a true picture of your business's performance: did you actually complete profitable work, or did you just get paid slowly?
Advantages:
- Reflects true profitability. Your profit figure shows what you've actually earned and spent.
- Required by company law for limited companies (with rare exceptions).
- Matches international standards, making it easier to attract investors or borrow.
- More informative for business decisions (pricing, staffing, expansion).
Disadvantages:
- More complex to administer. You need to track receivables, payables, accruals, and prepayments.
- Can show higher apparent profit than your actual cash position (you might owe the money; your customers might not have paid).
- Requires stronger bookkeeping discipline and often professional accountancy.
Cash Basis vs Accrual: Side-by-Side
| Factor | Cash Basis | Accrual |
|---|---|---|
| Income recorded | When paid | When earned |
| Expenses recorded | When paid | When incurred |
| Profit matches cash | Usually yes | Usually no |
| Admin complexity | Low | High |
| Legal requirement | Permitted up to turnover limit | Required for companies |
| Tax advantage | Often lower tax in early years | More accurate, longer term |
| Best for | Very small sole traders, cash-based services | Growing businesses, limited companies |
HMRC Rules: Who Can Use Cash Basis?
This is where HMRC draws a line. Cash basis is optional, not mandatory — but only if you meet the turnover threshold.
Sole traders and partnerships: You can choose cash basis if your turnover is below £300,000 (2025/26). Above that, HMRC requires accrual accounting. Below that, cash basis is available, but you don't have to use it.
Limited companies: You must use accrual accounting. No exceptions (well, almost — micro-entities have some flexibility, but that's beyond scope here). This is company law, not just tax law.
Trusts, charities, and other entities: Different rules apply, but most are required to use accrual.
Why does HMRC set this limit? Because accrual accounting is more transparent. A £300,000+ business has complex finances, longer payment terms, and more risk of manipulation. Accrual accounts show what's really been earned and spent, which HMRC prefers.
Many small businesses well below the £300,000 limit choose accrual anyway, because as they grow toward that threshold, they want to avoid the switch later. If you're approaching £200,000 turnover, starting accrual now is often less disruptive than switching suddenly at £300,000.
Which Should You Choose?
The choice depends on three factors:
1. Your turnover
If you're a sole trader above £300,000, you have no choice — accrual is mandatory. Below £300,000, cash basis is legal. If you're approaching £300,000, moving to accrual now is simpler than forcing a switch later mid-year.
2. Your cash flow
If you get paid quickly (retail, cash services, you invoice weekly and get paid in 7 days), cash basis is fine and simpler. Your profit on cash basis will be close to your true profit anyway.
If payment is slow (you invoice, your customer takes 60–90 days), cash basis distorts profit. You'll look unprofitable even when you're performing well. This is especially true in B2B (wholesale, construction, professional services). Accrual is clearer: did you deliver the work? Good. You earned the income. Pay taxes on that (the customer is responsible for paying you, not HMRC's problem).
3. Your accountancy cost
Cash basis is cheaper to administer — you and a basic spreadsheet can manage it. Accrual requires proper bookkeeping software or an accountant. If you're paying a bookkeeper £1,000+ per year to maintain accounts, the choice is partly made for you — you might as well use accrual and get proper reports in return.
Most accountants' advice: If you're going to have any admin beyond "rough numbers in a notepad," move to accrual. It's more work upfront, but it gives better information for business decisions, and you'll avoid the jolt of switching later.
Setting Up Your Accounting System
Once you've chosen, you'll need to tell HMRC. If you're self-employed, you declare your chosen method on your tax return. If you're a company, your annual accounts specify the method (it's essentially always accrual).
Our Making Tax Digital guide explains the software you'll need and how HMRC expects records to be kept. Both cash and accrual businesses need to record everything — the only difference is when you recognize income and expenses in your accounts.
If you're transitioning from cash to accrual, you might also need to make an adjustment in your first accrual year. An accountant can handle this, but it's worth knowing: if you switch and suddenly show a large profit increase (because you've recognized invoices that were owed in previous years), HMRC might query it. Explain the accounting change, and you'll be fine.
For businesses with employees, understanding your accounting method also ties into payroll. See our guide on calculating payroll tax for small businesses — whether you're on cash or accrual, payroll tax calculations stay the same, but accrual gives you clearer information on labour costs.
Tax Deductions and Both Methods
One common question: do I get different tax relief on cash vs accrual?
No. The tax deductions available to you are the same. You can claim business tax deductions like equipment, professional fees, home office, mileage, and insurance under either method. The timing of when you record the expense in your accounts differs, but HMRC allows the deductions either way.
Where it matters: on accrual, you record the expense when incurred. On cash basis, when paid. If you buy equipment in December but pay in January, accrual puts it in December's accounts; cash basis puts it in January's. That can shift which tax year you claim the relief — a small advantage if you're managing taxable income across two years.
Frequently Asked Questions
Q: Can I switch from cash basis to accrual accounting?
A: Yes. You simply change your method on your next tax return. HMRC will ask you to make an adjustment for any invoices outstanding at the date of change to avoid double-counting. Switching mid-year is messy; choose a tax year boundary.
Q: Does my accountant have to prepare accounts in a specific method?
A: If you're a company or you're above the £300k turnover threshold, accrual is mandatory. Below that, your accountant can use cash basis if you prefer, but they might recommend accrual for clarity. Ask them — it depends on your situation.
Q: What if I'm a sole trader and my partner is a company — do we have to use the same method?
A: No. You're separate tax entities. Your partner's company must use accrual (company law). You can stay on cash basis if you're below £300k. This can actually be useful for planning — talk to an accountant about whether it makes sense.
Q: Does HMRC prefer cash or accrual?
A: HMRC doesn't have a preference as long as you're above the threshold requirement. But accrual is more auditable and harder to game, so a higher-turnover business on accrual attracts slightly less scrutiny. Below £300k, either is fine.
Q: I'm invoicing clients but haven't been paid yet. Can I reduce my profit on cash basis to avoid tax?
A: Yes — that's the point of cash basis. You only pay tax on income actually received. However, if you're deliberately delaying invoices to manage tax, HMRC might challenge it (they look for patterns). The rule is: when you genuinely did the work, you can legitimately delay recognizing it on cash basis until you're paid. But if you're artificially deferring invoices or payments, you're in dangerous territory. Use cash basis as intended, not as a tax dodge.
Q: I'm about to hit £300k turnover. Do I have to switch immediately?
A: No. HMRC allows you to carry on cash basis for that tax year. From the next tax year, if your turnover was above £300k in the previous year, you'll need to switch. This gives you time to prepare — talk to your accountant now and get accrual accounts ready before you're forced into it.
Q: My VAT-registered — does that change which accounting method I use?
A: No. VAT registration and accounting method are separate. You can be VAT-registered on either cash or accrual. However, on accrual, you'll record VAT on invoices issued, even if not paid — which can affect cash flow. See our VAT registration guide for more details.
Q: How does depreciation work under cash basis?
A: On cash basis, when you buy equipment, you expense it immediately in the year you pay. On accrual, you depreciate it over its useful life (usually several years). This means cash basis can give you a larger tax deduction in the purchase year. It's one of the reasons some small businesses prefer cash basis — you get faster write-offs on equipment. See our depreciation guide for worked examples.
What to Do Next
If you're a sole trader under £300,000 turnover, your accountant (if you have one) will have already chosen a method. If you haven't discussed it, ask them: "Are my accounts on cash or accrual?" That one question will clarify your situation.
If you're running your own accounts, choose based on your cash flow and complexity. If invoices sit outstanding for months, accrual gives a clearer picture. If you get paid quickly, cash basis is simpler.
And if you're starting a limited company, use accrual from day one. You're required to, and it's the right choice for a growing business anyway. Our annual investment allowance guide explains how to claim equipment tax relief under accrual accounting — most common deductions work the same way.
The right accounting method isn't about paying less tax in the long run (you'll pay the same overall). It's about choosing the method that gives you accurate numbers for decisions and keeps you compliant with HMRC. Get it right at the start, and you'll save yourself chaos later.