Cash Basis vs Accruals Accounting: Which Should a Limited Company Use?

The fundamental difference between the two methods

Cash basis accounting records income when cash is received and expenses when cash is paid out. Accruals accounting (also called traditional accounting) records income when it is earned — that is, when a sale is made or a service is performed — and expenses when they are incurred, regardless of when the money actually changes hands. For a company that invoices on 30-day terms, this means revenue for December work appears in the December accounts even if the customer pays in January.

The matching principle that underlies accruals accounting ensures that income and the costs associated with generating it are recognised in the same period, giving a more accurate picture of trading performance in any given period. Cash basis figures can be misleading because a good cash month might follow a strong sales month from the prior period, or vice versa.

Why limited companies cannot use the cash basis

The cash basis for tax was introduced by HMRC as a simplification for small unincorporated businesses — sole traders and simple partnerships — with income below a certain threshold. It has never been available to limited companies. Limited companies must prepare their statutory accounts under either FRS 102 (the UK GAAP standard for most companies) or FRS 105 (the micro-entities standard), both of which require the accruals basis. The Corporation Tax computation is then derived from those accruals-basis accounts.

This means a director cannot choose to recognise income only when invoices are paid, or to defer the recognition of a cost until the invoice arrives. Standard accounting adjustments — accruals for costs not yet invoiced, prepayments for costs paid in advance, work in progress for partly completed contracts — must all be applied at year end.

Practical implications for directors reviewing their own accounts

Understanding the distinction helps directors interpret what they see in their P&L. A profitable accruals-basis P&L does not mean cash is in the bank — if debtors are growing, cash may be being absorbed by unpaid invoices. Conversely, a business sitting on a cash surplus might still be recording a loss if significant costs have been incurred but not yet paid. This is why reviewing the balance sheet alongside the P&L is essential, and why a cash flow statement — even an informal one — is a valuable addition to any management accounts pack.

If you are transitioning from being a sole trader to a limited company, the move from cash basis (if you were using it) to accruals basis can create a one-time tax difference. Your accountant should model this in advance of incorporation so there are no surprises in the first company tax return.