What are the benefits of calculating VAT on a cash basis?
Posted on 27th February 2020
When your business is VAT registered it comes with a range of benefits, especially if you predict growth for your business in the future. It means you can reclaim VAT on your business costs, and can also help to give your small business the appearance of a bigger and better established company that can sometimes help inspire buyer confidence. It is for these reasons that many businesses choose to register voluntarily, but remember, once your turnover reaches a certain threshold (over £85,000) you will be legally required to register for VAT.
However, with VAT registration comes a set of responsibilities. You’ll be responsible for working out your own VAT (though your accountant can do this for you - but you will ultimately be responsible for ensuring it's correct) and be responsible for its accurate accounting. There are two ways in which you can do this - accrual accounting and cash accounting. Both have their pros and cons, however here we’re going to concentrate on the latter.
What is cash accounting for VAT?
The primary difference between cash and accrual accounting is the point at which VAT is calculated. For cash accounting this means it is calculated at the point where your invoice is actually paid rather than the point at which it is received or issued. While this is referred to as “cash basis” it refers to payment of any kind including cash, cheque, standing order, credit or debit card and part payments.
Similarly, VAT can also only be reclaimed on purchases when suppliers have paid their invoices.
Please note that this is not applicable for goods bought or sold under lease or hire-purchase agreements, conditional sale agreements, supplies invoiced in advance of delivery or where full payment is not due within six months.
What are the benefits of cash accounting?
Cash accounting can bring a multitude of benefits for small businesses. For starters, it can potentially make the business of VAT accounting much simpler to calculate. Most business owners find it easier to keep track of money coming into and out of their business rather than the more ephemeral nature of when invoices are received. Furthermore, because VAT is calculated only after the point of payment, it can make things a lot easier on the cash flow too.
Quite a few small businesses - especially those with smaller turnovers or in their early days - have a precarious relationship with their cash flow. Accounting for VAT in this way can prevent oversights from impinging on your cash flow and in turn prevent the dreaded taxman from taking his due from payments that have not yet entered your business account..
Are there any disadvantages?
While cash accounting is advantageous for many, it may have its disadvantages for some. While no output tax is due until the business has received payment, that means that there is no input tax recovery on invoices which have been issued but not paid.
Small businesses that are in their first couple of years may not benefit from calculating on a cash basis. This is because they might have higher expenditure rates as they purchase their initial equipment and pay for other overheads. As such, their input tax will be greater than their output tax and so it may be beneficial to account on the basis of when invoices are sent, rather than payments are received.
What kinds of business benefit the most from calculating VAT on a cash basis?
Any business can apply for this method of VAT calculation so long as its annual turnover is less than £1.35 million, is up to date on its VAT returns, has paid or arranged to pay for all VAT due and has not been convicted of any VAT offences in the previous financial year.
Those who benefit the most from this form of tax calculation tend to be smaller businesses with low profit margins and a modest annual turnover. If your business's turnover exceeds £1.6 million the accrual method of calculation is mandatory, and you will be expected to switch to this scheme immediately.
As long as your business is eligible and meet all of the criteria listed above, you can use this scheme without informing HMRC up front.
While we have tried to be as thorough as possible here you may still have questions about calculating your business’s VAT on a cash basis - and, as with all tax related queries, there is no 'one size fits all' response!
Take a look at this VAT factsheet which summarises everything covered here as well as some extra details which you may find useful.
Needless to say, we’re also more than happy to discuss any matters relating to any aspect of VAT or tax in general! Feel free to get in touch with us today to see how we can ease your tax and accounting headaches. Feel free to give us a call or drop us an email. We’ll be more than happy to help advise you, taking your individual circumstances into consideration.
Nicola J Sorrell -
Founder | Xero Champion | IR35 Expert
Tagged as: VAT
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