When you are registering as a sole trader, one of the things you have to consider involves the accounting system you want to use. You can choose to use either cash basis accounting or traditional accounting. Many sole traders end up choosing cash basis but it’s important to get accustomed to both – the accounting style you choose can have a huge impact on the filing process, the expenses and claims you can make, and your peace of mind!
Traditional accounting for sole traders
In traditional accounting, you record your income and expenses regardless if you’ve been paid or not. This means that if you invoice a customer on March 28th 2019, which would be part of the 2018/19 tax year, you need to file it for that tax year even if the customer pays you on April 20th 2019 (which falls under the 2019/20 tax year). In essence, you’ll use your invoices as the basis for your accounting rather than your bank statements.
When you are using traditional accounting, you will need to keep records of all income and expenditure. This includes things like:
- Business bank assets
- Value of stock at the end of your accounting period
- Any payments made to employees
- Business vehicles and travel costs
- Bank or building society interests
The benefits of traditional accounting
There are advantages to using traditional accounting. The system is generally better when your business is big and more complex. For instance, if you have a lot of stock or you need to file for VAT, the method is helpful. Traditional accounting can also be advantageous if you need to offset against other taxable income in what is called the ‘sideways loss relief’. This means you can carry losses back and use them against profits made in the previous year.
Cash basis accounting for sole traders
On the other hand, cash basis accounting is straightforward and easy, as you are simply recording your income and expenses at the time you receive or spend the money. If we look at the earlier example, you would file the payment for the 2019/20 tax year because you received the payment on April 20th 2019, which falls to that tax year rather than the tax year during which you invoiced it. In cash basis accounting, you can focus on your bank statements rather than invoices.
The benefits of cash basis accounting
Cash basis accounting is the recommended choice for sole traders with smaller businesses, especially those selling services. The process is straightforward and simple, taking the stress out of filing your taxes as a sole trader. You are essentially just focusing on what you earned and spent on the tax year.
The treatment of expenses
When choosing whether to use cash basis accounting or traditional accounting, you want to consider the treatment of expenses as well as income. Sole traders are given the option to opt for the ‘simplified expenses scheme’, which is especially useful for those using cash basis accounting. This allows you to calculate certain expenses using flat rates instead of working out the actual business costs. Flat rates can be used for:
- Your car – But only if you’ve not claimed capital allowances for it or when you haven’t included it as an expense when counting business profits.
- Working from home – Notice that the flat rate doesn’t include telephone or internet expenses and the simplified scheme is only available when you work for 25 hours or more a month from your home.
- Living in your business premises.
HMRC has a great checker online to allow you to compare whether using flat rates would suit your business better than calculating the actual costs.
The flat rate scheme is available for sole traders, whether you are using the cash basis or traditional accounting. However, it’s important to note that cash basis accounting will restrict your options to:
- Claim loss relief – you can’t offset any losses you make against your other income backwards.
- Claim relief for interest to a maximum £500 per year.
- Claim capital allowances on anything other than cars and payments for equipment are always allowable expenses.
When it comes to tracking expenses, we recommend you read the post we did on the best ways to track them before getting started.
Which accounting system is better for you?
As the above shows, there are benefits to both systems. Ultimately the right option depends on your specific needs. For example, if your business is turning over a lot of money and your income is above the VAT threshold, traditional accounting is easier. In fact, you might even want to consider setting up a limited company and you can find out more about the process and the benefits from our previous blog post. Just keep in mind that if you do set up a limited company or business partnership, you won’t be able to opt for the flat rate expenses schemes!
However, if your business is currently earning below the thresholds, cash basis accounting is the easiest choice for sole traders. It makes accounting simple – you are noting what you spend and earn during the tax year. However, the treatment of your expenses will be slightly different which is why you might find traditional accounting easier.
Get help with your sole trader accounting
When it comes to choosing the right accounting system and the filing of your taxes as a sole trader, a little helping hand can make the process smoother. At Devonshire Green, we’ve worked with countless sole traders in a variety of fields so we know what a sole trader like you actually needs. We get straight to the point and help you solve your accounting problems without any extra complexity. Contact us today and together we can get your accounting on the right track!