Here’s how to understand traditional accounting (also known as the accruals basis). Plus, I’ll explain how it affects the numbers you need when you fill in your tax return.
Friendly Disclaimer: Whilst I am an accountant, I’m not your accountant. The information in this article is legally correct but it is for guidance and information purposes only. Everyone’s situation is different and unique so you’ll need to use your own best judgement when applying the advice that I give to your situation. If you are unsure or have a question be sure to contact a qualified professional because mistakes can result in penalties.
1. What is Traditional Accounting (Accruals Basis)?
Traditional accounting is an accounting method used where you include income and expenses that were invoiced or billed during the accounting period you’re using for your tax return. This is known as the matching concept, and it is also referred to as the accrual basis in accounting. It means you’ll pay tax and national insurance whether your client has paid you or not, and that you might need to calculate accounting adjustments like:
2. Do You Have to Use Traditional Accounting for Your Tax Return?
When it comes to filling in your tax return, you can choose to use the accruals basis or cash accounting. Cash accounting means you only include business income and expenses paid during your accounting period on your return. You can only use one method for one tax year. You can change from the cash basis to traditional accounting between different tax years. However, you must use the same one for each complete accounting period and have a reason for making a change such as using tax losses. If you want to switch between the two, you need to make sure you make adjustments to the numbers you put on your tax return. This is to ensure you don’t double count or omit income and expenses.
3. Traditional Accounting v Cash Basis, What’s Right?
Traditional accounting can be a bit more complicated to use if you are DIY-ing your business finances. The accounting method that is right for you really depends on your personal circumstances. Let’s suppose that during the tax year 2020/2021, you invoice a customer £2,000 and they part paid your invoice sending you £1,000.
Using the cash basis, you would only include £1,000 in your income on your tax return. But using traditional accounting, you’d need to show the full £2,000 and pay tax on this.
However, let’s say you are setting up your business and have been invoiced £5,000 for your new website. You’ve only paid £2,500 to your web developer during the tax year 2020/2021, agreeing to pay the balance at some point during 2021/2022.
Using the cash basis, you would claim £2,500 as an expense in 2020/2021 and the rest in the subsequent year. But with traditional accounting, you’ll be able to claim the invoice value of £5,000 in one tax year meaning you get the tax benefit sooner rather than later.