The case against cash accounting

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AccountingWEB is starting a call for cash accounting for small businesses in UK tax returns. It's calling it Cash Accounting for Small Enterprises, or the CASE for Cash. I'm surprised that Taxation magazine are joining in.

I have to admit I think that this campaign is misguided for these reasons.

1. This is not a tax issue, but an accounting one.

The rules for accounting are not set by our taxation authorities. They are set by the DTI, who by default have delegated them to the accounting profession by the effective adoption of UK GAAP into company legislation. By inference this means that the same GAAP (as expressed for the vast majority of UK businesses through the Financial Reporting Standard for Smaller Entities) applies to all unincorporated UK businesses, although that standard provides almost no guidance on how that should be done.

To therefore raise this issue as one relating to taxation is wrong. It has to be raised as an accounting issue. In that context it's also important to note that many of the frustrations in small business accounting and tax of late have arisen out of accounting issues e.g. the UITF 40 debacle was entirely of the profession's creation. The Revenue simply had to sit back and watch the mess we made.

2. Accountants should not give up on 'true and fair' accruals accounting

I have to admit that I presume that this issue has been promoted by tax accountants with no interest in business. Anyone who is interested in business knows that to ignore debtors and creditors, as cash accounting systems might suggest appropriate is to prescribe a disaster for small businesses. Those who do not keep the closest eye on debt, stock control and creditors fail. It's as simple as that. Running out of cash is the biggest cause of small business failure. And cash accounting would, if promoted, encourage that. It would be negligent of a profession that claims to have the best interests of the small business community it serves, and which provide it with its lifeblood, to promote such a standard.

Of course it is true that for some small businesses (as the promoters of cash accounting note) the cash basis is almost identical to the accruals basis of accounting. But what sort of argument is that for cash based accounting to be applied generally? For these people accruals accounting is not a burden anyway - they are effectively on a cash basis. But to ask others to prepare wholly misleading accounts to come into line with those for whom accruals based accounting is not, as a matter of fact, needed seems a nonsensical argument.

And for accountants to believe that the sole purpose of their work is to agree tax affairs seems to consign the profession to a role as mere technicians at best, and maybe irrelevance at worst. I would hope that we think accounts of substantially more use than that. If we don't, it says little for us, and nor does it convey the important message that even for small enterprises where debt, liabilities and stock need managing accounts are one of the vital tools that enhance the prospect of business success. We should be promoting this understanding if we want a healthy enterprise economy, not shooting ourselves and our clients in the foot.

3. Cash accounts are not simple.

I have to point this out. Cash accounting requires a cash receipts and payments record. But it also requires that these receipts be analysed between sales and other income, and that the expenses by analysed by type to ensure their appropriateness for tax deductibility. On the sale side this therefore requires either a takings record or a sales listing (lets call it a sales day book). Any practitioner worth their salt will want to either do a sales ledger control account or cash account to ensure the completeness of income declaration by their client. To not do so is, I think, negligent. So, an accruals basis will have to be used in many cases. And if it isn't, the Revenue might well have questions to ask later. As for payments, a record of all purchase invoices and receipts will be needed as evidence of the appropriateness of the claim being made for the expense. The only difference between an accruals and cash basis will be that an accruals basis might bring forward a claim for some of the expenses. That should help compensate for the cost of having to keep the record, and having to analyse it in detail, as will still be required.

In other words, debtors and creditors remain vital in accounting on a cash basis if cash based accounts are to be correctly stated.

That leaves accruals and prepayments (less than 10 minutes work in my experience for most small businesses, and highly predictable as to their nature) and stock and WIP. The latter is a pain - and UITF40 has made it absurd. It is clearly inappropriate for smaller enterprises and unincorporated ones. But that's not a justification for cash accounting. It's a justification for a simple method of accounting for stock and WIP. Candidly, until UITF40 came along I think we had that. Let's restore it. It's simply 'the lower of cost and net realisable value' and be done with it. And income recognition must be on the basis of invoices. And again, let's be done with it.

Then there is really no saving from cash accounts that can justify the change.

4. Cash accounting may well lead to more accounting errors.

Dealing with the Revenue on bank deposits is hard enough now. Under cash accounting you can imagine it will become just about impossible. All deposits will be taxable; that's the premise of the system.

And you can also imagine that people will think the difference between the year opening and closing balance if their income. Talk about creating an expectation gap. Those misled will face serious investigations. The profession will be asked why it takes so long to deal with something they claim is simple, when it isn't. You can imagine the downward pressure on fees that will create.

5. The Revenue won't wear it.

Let's be candid. The Revenue is not going to buy this, and as a campaigner I never recommend backing a lost cause. The reasons for its unacceptability are obvious:

- It will be easy to avoid tax by simply stacking the deposits to be paid in the first day of the next accounting year. No revenue authority is going to allow a system which makes avoidance that easy.

- Cash accounting has to imply 100% capital allowances, or it's not cash accounting. But this removes a tool of economic management. I can't see that being foregone. No flat tax state does, for example, give automatic 100% capital allowances even though they are inherent in the theory of that system.

- The transition rules from a cash system to an accruals system as a business grows are too horrible to contemplate. Think about the claims people will start making for transitional relief. These can be avoided by having just one income recognition system.

- It's just about impossible to believe corporate accounting could be on a cash basis and that any meaningful concept of limited liability and the protection of creditors could be maintained and so the chance of their being cash accounting for corporates is highly unlikely. I can't see the Revenue wanting entirely different accounting concepts for small entities dependent upon their choice of trading media.

This list could be extended, very easily.

6. People will still need accrual accounts.

I have a strong suspicion that cash based accounts won't be accepted for lending purposes because they are too easy to manipulate. In that case two entirely separate sets of accounts will be needed, one for tax and one for a true and fair view of income to be presented. Which client is going to thank us for the additional work and cost involved in preparing two sets of accounts?

Summary

There are exceptionally good reasons for believing the accounting standards setters in the UK are getting the accounting requirements of all smaller entities (not just micro ones) wrong, and that the profession (not anyone else) are imposing undue burdens on business as a result. But cash accounting is the wrong solution for an accounting profession that still believes it has a role as all-round advisers to small business because such a system of accounting would significantly harm that sector.

Can we instead look at a really simple accounting standard that is appropriate for small and micro entities, building perhaps on the one the UN has developed? I will return to this theme.