Joe Brough explains how the transitional rules should be applied when eligible businesses make the switch from accruals accounting to cash accounting following their change to the default basis of calculating taxable profits from 2024/25.
For tax years preceding 2024/25, a business could only enter the cash basis if its turnover was less than £150,000 per year, and it had to leave once its turnover exceeded £300,000.
From the start of the 2024/25 tax year, the turnover threshold has been removed, with the cash basis being made the default way for businesses to calculate their taxable profits, although accrual accounting can still be used should a business wish to do so.
Not all businesses are eligible to use the cash basis. The full list of excluded trades is provided in ITTOIA 2005, s 25B, and includes the following:
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companies;
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limited liability partnerships;
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partnerships with a corporate partner;
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businesses with a current herd basis election;
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businesses which have claimed a research and development allowance; and
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businesses which carry on a mineral extraction trade.
For a business using the cash basis, income and expenses are accounted for when it physically receives money from sales, and pays money out for purchases. In contrast, when using accruals-based accounting, income and expenses are accounted for by reference to the period to which they relate, irrespective of whether they have been paid by the year end.
How a business determines whether a sale or purchase has been paid within an accounting period is open to interpretation. For example, is a sale ‘paid’ when a cheque is received, or when it clears the bank? HMRC does provide guidance on this point in their Business Income Manual at BIM72005, which states that a business can make its own decision as to which definition they use; however, it must be consistent in its application from year to year.
Transitioning to the cash basis
Where a business has previously used the accruals basis, when switching to the cash basis, transitional rules apply to ensure that income and expenses are not duplicated in both periods.
For example, under accruals accounting, a business will include trade debtors as part of its turnover. If in the following period, the cash basis is used without transitional rules, this income would be counted again once received, with the result that tax is paid on the same income twice.
Below are examples that are likely to be seen in practice and how these are adjusted for in the transitional period:
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Stock and work in progress – under accruals accounting, closing stocks and work in progress are included as a deduction from cost of sales. Without a transitional adjustment, no deduction would be given for these expenses. Opening stocks are included as a deduction in the first cash basis period.
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Trade debtors – under the cash basis, income is brought into account in the period it is received. Under accruals accounting, trade debtors will already have been included within turnover. To avoid double counting, a transitional adjustment to deduct opening trade debtors from turnover will be required.
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Trade creditors – under accruals accounting, these costs will have been included within expenses. Therefore, these costs will need to be added back to trade profits on transition to prevent them from being double counted.
Example 1: Transitional adjustments
Sophie has previously drawn up her accounts up to 31 March each year using the accruals basis. As she will not be electing to remain on the accruals basis for 2024/25, she will be required to make transitional adjustments to her first set of accounts under the cash basis.
Included within her accounts to 31 March 2024 are the following:
Closing stocks: £500
Trade debtors: £1,000
Trade creditors: £750
Her trading results for the year ended 31 March 2025 under the cash basis and transitional adjustments required are shown below:
31 Mar-25 Transitional Adjusted
Adjustment P&L
£ £ £
Sales: 15,000 (1,000) 14,000
Cost of sales (5,000) (500) (5,500)
Gross profit 10,000 (1,500) 8,500
Overheads (2,000) 750 (1,250)
Net profit 8,000 (750) 7,250
Capital allowances
Additional adjustments are required if a business has any unrelieved capital expenditure within its capital allowance pools on transition.
Under the cash basis, capital expenditure is included as a deduction in the year in which it is paid, rather than by claiming capital allowances. If a capital item is sold, the proceeds are treated as a trading receipt in the period in which it is received.
The rule on treating capital costs as expenditure is, however, subject to certain exceptions. For example, if a car is purchased, this is still dealt with by calculating capital allowances, with the purchase of land along with any incidental costs of acquisition not being allowable as a deduction from trading profits at all.
If, on transition, there are any unrelieved balances within the capital allowance pools, these amounts are given as a deduction from trading profits in the transitional period. However, for this rule to apply, the pool balance must represent expenditure which would have been deductible under the cash basis rules on normal principles.
For example, if the general pool balance is represented by a car, then this would not be available for deduction, with capital allowances continuing to be claimed. If there is a mix of assets, some of which would be allowable as a deduction under the cash basis rules, HMRC will allow a proportion of the pool balance to be claimed as a deduction, calculated on a just and reasonable basis in proportion to the total pool balance.
Assets on finance
If a business has financed the purchase of an asset (e.g., under a hire purchase agreement), a further adjustment is needed to reflect the unpaid balance as at the date of transition. This is needed because a deduction for the repayments will be an allowable deduction under the cash basis.
As tax relief may already have been claimed via capital allowances, this will result in a double counting of the costs, with too much tax relief being claimed.
Example 2: Sophie’s capital assets
Continuing with the example of Sophie from above, let us assume that on transition Sophie had a general tax pool balance of £10,000, of which £8,000 represents a car which is used 100% for business purposes and computer equipment costing £5,000, of which only £3,000 of capital allowances have been claimed.
If these balances are apportioned on a just and reasonable basis, Sophie would be able to claim a transitional expense of £2,000 in relation to the unclaimed computer costs in her first cash basis period. She would then be able to continue claiming writing-down allowances on the value of the car against her taxable profits.
At the date of transition, the finance balance owing on the computer was £4,500, with Sophie repaying the loan at £100 per month. Under the cash basis rules, the monthly repayments are deductible as a business expense. However, the unpaid balance as at the date of transition would need to be included as a trade receipt, to ensure that tax relief was not given twice.
The effects of these adjustments are as follows:
Computer: £
Unrelieved pool balance on transition: (2,000)
Finance balance as at 01/04/2024 4,500
Repayments during the year (£100 x 12) (1,200)
Net adjustment to add to profits 1,300
As Sophie has already claimed capital allowances of £3,000, the effect of the adjustments means that an overall deduction of £1,700 has been claimed. This is equivalent to the original cost of £5,000 less the closing balance owing on the finance agreement at the end of the transition year of £3,300.
As a main rate pool vehicle, the car will receive a writing down allowance of £8,000 x 18% = £1,440.
Accounting for VAT
Some businesses using the cash basis may be registered for VAT. If so, a simplification is available which gives them the option of using the VAT-inclusive cost of their income and expenses to calculate their taxable profits.
However, if this simplification is used, it is important to remember to include the VAT receipts and payments made to HMRC as business income and expenses respectively, as otherwise the taxable profits will be incorrect.
Practical tip
If a business would prefer to use accruals accounting for 2024/25 onwards, this must be indicated on the tax return by putting an ‘X’ in box 10 on the full self-employment pages, or box 8 for the short self-employment pages; otherwise, HMRC will assume that the cash basis has been used.
