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HMRC internal manual

Business Income Manual

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HM Revenue & Customs
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Cash basis: transitional adjustments: entering the cash basis: examples: accruals and prepayments

Other items not represented by cash payments or receipts

Certain accounting adjustments can be made to the profit figure when using the accruals basis of accounting. An accrual accounting adjustment brings in an expense in advance of making payment or receiving an invoice. A prepayment accounting adjustment is made when a business pays in advance for a service that will take place over a period of time. Similarly, an accounting adjustment is made when the business receives income in advance of supplying its customer. There are examples of these adjustments below

Any of these accounting adjustments in the last tax year (before using the cash basis) will mean that transitional adjustments will have to be made in the first cash basis period. Otherwise, the business will pay the wrong amount of tax.

Examples:

Expense accrued at the end of the last tax year

A business included a £200 expense for electricity it used in the final month of its last tax year but had not paid yet. The subsequent electricity bill (which also covered the first 2 months of the cash basis period) was for £800, which was paid in the cash basis period. Unless a transitional adjustment was made, the business would get tax relief twice on the £200 that had been accrued (once as the accrued expense in the last tax year, and again in the cash basis period as part of the £800 bill payment). Total power bills paid in the cash basis period were £3,000.

Transitional adjustment:

Power bills paid £3,000
   
Less: amount accrued in previous tax year (£ 200)
Adjusted cash basis power costs £2,800

Prepayment made in the last tax year

A business made a payment of £1,200 for a 12 months cleaning service contract (to clean the business’s equipment). The payment was made 2 months before the end of its last tax year. So the £1,200 covered 2 months of the last tax year, and also would cover 10 months worth of cleaning in the following period (so it was a prepayment), which was the first cash basis tax year. Under accruals accounting, there was a tax deductible expense of £200 in the last tax year, with a £1,000 prepayment balance carried forward into the cash basis period.

If a transitional adjustment was not made, the business would not get a tax deduction for the £1,000 prepayment balance (because the £1,200 cash payment to the cleaners was made before the cash basis period began).

Transitional adjustment:

Amounts paid for repairs, servicing and cleaning in cash basis period £2,356
   
Plus: amount prepaid in last tax year £1,000
Adjusted cash basis cost £3,356

Income received in advance, in the last tax year

The business received a payment of £6,000 from a customer in its last tax year. This was in exchange for making and selling 12 sets of furniture (£500 per set) to that customer. By the end of the last tax year, 3 sets of furniture had been made and sold. Under accruals accounting, there was £1,500 of sales income taxed in the last tax year (3 x £500). The £4,500 balance of the £6,000 was ‘income received in advance’, which was not taxed in the last tax year.

If a transitional adjustment was not made, the business would not be taxed correctly because the whole £6,000 was received before the cash basis period began.

Transitional adjustment:

Total cash receipts from customers £55,000
   
Plus: income received in advance  
in the last tax year £ 4,500
Adjusted cash basis receipts £59,500