Switching from Cash Basis to Accrual Accounting: A Guide for Small Businesses

Running a business is about building a future. But how do you plan for that future when your financial reports only show what’s in the bank today?

True planning, forecasting costs, setting budgets, and making decisions, needs a clearer, more predictive view of your finances.

For small businesses, cash basis accounting makes things simple: record income when received and expenses when paid. But its simplicity hides what customers still owe you or what you owe suppliers, often giving a misleading picture of profitability.

That’s where accrual accounting helps. It matches income and expenses to when they actually occur, offering a truer view of performance. With that clarity, you can budget smarter, forecast better, and grow with confidence.

A Simple Breakdown: Cash Basis vs Accrual Accounting 

Let's break down the jargon. Think of it like this:

• Cash Basis Accounting (Your current method, likely): You record money when it's actually received in your bank account, and expenses when they're actually paid from your bank account. It’s great for seeing your current bank balance.

• Accrual Accounting (The upgrade): You record income when you earn it (e.g., when you've delivered the service or product), even if the customer hasn't paid yet. And you record expenses when you incur them (e.g., when you receive a bill), even if you haven't paid it yet.

Analogy: If you sent an invoice in January but weren't paid until February, under Cash Basis Accounting, you'd record the income in February. Under Accrual, you'd record it in January, because that's when you earned it.

Why this matters to you: Accrual gives a clearer picture of your financial performance over time. It matches your income with the expenses that generated it, revealing your true profitability.

Explore Next: Cash and accrual basis accounting: What is the difference?

Why Do Small Businesses Switch to Accrual Accounting?

Switching your accounting method is a powerful way to solve common growth challenges. Here's a closer look at what accrual can do for your business.

• A More Accurate Picture: See your business’s true financial health, beyond the bank balance. This is vital for assessing patterns and long-term profitability.

• Better Decision Making: With clearer financial data, you can make more informed choices about pricing, investment, and growth.

• Managing Credit & Inventory: If you offer credit to customers or buy stock on credit, accrual accounting helps you track what's owed to you (accounts receivable) and what you owe others (accounts payable), which isn't typically tracked on a cash basis accounting. It also provides a much more robust cash flow management.

• Meeting Lender/Investor Requirements: Banks, lenders, and potential investors often prefer or require financial statements prepared using accrual accounting, as it aligns with generally accepted accounting principles (GAAP).

• Easier Growth: As your business scales up, accrual accounting becomes necessary for a comprehensive financial overview.

Explore Next: Bookkeeping and Taxes: When to Outsource?

Is It Time for Your Small Business to Upgrade?

HMRC encourages cash basis accounting for smaller businesses and it's the default method for self-employment accounts from the 2024/25 tax year onwards. You have to elect to use accrual accounting on your Self Assessment tax return if you prefer it. However, there are compelling reasons to consider the switch, regardless of turnover thresholds or defaults.

• Do you offer credit to customers or buy on credit from suppliers?

• Do you carry inventory or stock

• Are you seeking external financing (loans, investors)?

• Are you struggling to get a clear picture of your long-term profitability?

Tax Implications: Switching impacts how income and expenses are recorded for tax purposes. While cash basis accounting offers some tax planning flexibility, accrual basis accounting provides consistent matching of income and expenses, which can be advantageous. There are specific rules for transitioning to ensure correct overall taxable profits, including a spreading adjustment over six years, which can be accelerated.

Your Step-by-Step Guide to Making the Switch

The change takes planning. Transitioning involves adjustments to your accounting system and financial records. Key steps include:

• Review your current financial records: This is your starting point. You need to go through all your existing financial records to pinpoint exactly where your cash basis accounting figures diverge from what they would be under accrual. This helps identify where adjustments are needed before the formal change.

• Record outstanding invoices (Accounts Receivable): Under accrual accounting, income is recognised when earned, even if the cash hasn't arrived. Identify all invoices issued to customers for goods or services already delivered but not yet paid. These become your starting "accounts receivable".

• Record outstanding bills (Accounts Payable): Similarly, expenses are recognised when incurred, not when paid. Go through all your supplier bills that relate to services received or goods purchased before your switch date but haven't been settled yet. These represent your opening "accounts payable".

Adjust for Prepayments and Accruals:

• Prepayments: These are expenses you've paid in advance (like annual insurance). Under accrual, only the portion of the expense that relates to the current period is recognised. The rest is recorded as a prepayment (an asset) on the balance sheet and expensed gradually over time.

• Accruals: These are expenses incurred but not yet billed or paid (like electricity used but not yet invoiced). You'll need to estimate and record these expenses in the period they were incurred, creating an accrued expense liability.

• Consider Fixed Assets: The way you account for capital equipment (e.g., machinery, vehicles, property) changes. Under accrual accounting, fixed assets are recorded on the balance sheet and their cost is systematically allocated as depreciation expense over their useful life. This gives a more accurate picture of the asset's use in generating revenue.

• Update your accounting software: Most modern accounting software, such as Xero, QuickBooks Online, Sage 50cloud, and FreeAgent, can support accrual accounting. You'll need to configure your existing software or set up a new system to properly handle accrual-based entries and reporting.

• Understanding the Spreading Adjustment: HMRC rules ensure that overall taxable profits are correct by taxing income and deducting expenses only once during the transition. Any additional income from the move is usually spread over six years for tax purposes, though you can elect to accelerate it.

It requires meticulous record-keeping and potentially updating your systems and processes.

Frequently Asked Questions

1. What is the main difference between cash basis accounting and accrual accounting?

Cash basis records income and expenses only when money changes hands, while accrual accounting records them when they’re earned or incurred, giving a more accurate financial picture.

2. When should a small business switch from cash basis to accrual accounting?

Businesses should switch when they start offering credit, managing inventory, or seeking funding. Accrual accounting helps track receivables, payables, and overall performance more accurately.

3. Does HMRC allow switching from cash basis to accrual accounting?

Yes. HMRC allows small businesses to switch methods, but you must adjust your records correctly to avoid double-counting income or expenses and ensure tax compliance.

Ready To Take Control of Your Finances?

You don't have to do it alone. Converting from cash to accrual basis accounting can feel daunting, but with the right guidance, it can be seamless. This is where AMS steps in. We specialise in supporting UK small business owners with their accounting needs. We can help you:

• Assess if switching is right for your business, considering your size, industry, and goals.

• Navigate HMRC regulations and tax implications specific to UK small businesses, ensuring compliance during and after the transition.

• Perform the necessary adjustments to your financial records, including recording accruals and deferrals.

• Set up or migrate your accounting software (e.g., Xero, QuickBooks) to properly handle accrual basis accounting.

• Provide training and ongoing support to you and your team, making sure you're comfortable with the new system.

• Ensure your financial reporting is accurate and compliant, ready for lenders, investors, or simply for better internal decision-making

Now you know that switching to accrual accounting is a strategic move that gives you a more accurate and powerful view of your business’s financial health.

With this clarity, you can make smarter decisions, plan for real growth, and build solid credibility. While cash basis accounting might be easy for some, for your ambitious small business, accrual basis accounting offers the deeper insights you need to thrive.

Need help making the switch? AMS is here to make it simple.