This article discusses cash vs accrual accounting as accounting methods, provides a case study, and offers tips on which method is suited for your business.
Does your business run on a cash or accruals basis? Do you understand the difference? If not, then this article will help you understand what the terms mean and what impact it may have on your small business.
Let’s take a closer look at what the two methods of accounting mean:
- Cash basis: this approach recognises income and expenses when they happen, that is, when the money arrives into or leaves your business bank account.
- Accrual basis: this approach recognises income and expenses when they are invoiced or when a bill is received. The timing of the income and expense and the impact on your business profit and loss statement is completely independent of when the money comes into or leaves your business bank account.
So the difference between cash and accrual accounting comes down to timing. As a business owner it is important to understand which method your accountant uses for keeping track of the finances of the business so that you can make the most informed decision on the timing of expenditure and income.
When your business uses the cash accounting method it does not recognise accounts receivable or accounts payable. When you pay an invoice it would be entered into your bookkeeping system as of the date it is paid. Each quarter your Business Activity Statement (BAS) would be prepared on money received and spent within that BAS period. The financial activity is more aligned with the business activity and this method is a more straightforward method that makes sense to many small business owners. The upside is that you get an immediate snapshot of your money in the bank account, but you still need to plan for upcoming large expenses and manage your cash flow.
One mistake small business owners often make is thinking that all the money in their bank account at the end of the week or month is profit – but there are quite a few more issues to consider (tax being the biggest one!) before you withdraw the money out of the business for your own personal use. Cash-based accounting is available to businesses with a turnover of less than $10 million but even if your business has a turnover of less than this you or your accountant can choose to use the accrual method if they believe it is to the business’s benefit. One other thing to consider is that a small business can have their quarterly BAS prepared on a cash basis, while their annual tax return is prepared on an accruals basis.
When your business uses the accrual accounting method it recognises income when the invoice is generated and expenses when a bill is received. It is a more complex system and requires you to have a greater understanding of the balance sheet. There is still the need for cash flow planning of course but this method shows your business’s true financial position when your accounts receivable and payable are kept up-to-date. It means that you know what people owe the business and what you owe so that you can make better-informed business decisions. The accrual method might be better suited to companies that allow longer payment terms or where contracts are paid over time and where they have reasonably large accounts with suppliers.
a case study: cash vs accrual accounting
Your supplier invoices you for the materials you ordered for the job you are doing next week when they will deliver them to the worksite. The invoice is dated the 10th of June and the payment due date is the 10th of July. You pay the bill on the 9th of July. What are the implications for both your quarterly BAS and for your tax position in your business tax return? If your business is:
- on a cash BAS, the expense will be picked up in the September quarterly BAS cycle, even if you entered the bill into your bookkeeping system when you received it.
- on an accruals BAS, then the expense will be picked up in the June quarterly BAS cycle regardless of when you paid the bill.
- using the cash accounting method, the expense will be in the ‘Materials’ line item in your profit and loss statement for the following year and won’t impact the tax return for your business in this financial year as you paid it after the 30th June.
- using the accrual accounting method, the expense will be in the ‘Materials’ line item in your profit and loss statement for this financial year and will flow through as an expense to the tax return in this financial year. Because you haven’t paid the bill yet, there will be an amount sitting in the accounts payable account on your balance sheet (a liability) as at 30th June.
Knowing how your accounting is done may help you make more informed decisions on the timing of out-of-the-ordinary expenses for example or invoicing a large amount to a client. You may want to defer the income until next year or you may want to take up bigger expenses this year and the accrual system allows you to better manage the timing to suit your financial circumstances from year to year.
what’s best for your business?
Between cash vs accrual accounting, which one should you use? Generally, very small businesses are better off using the simpler cash method. However, as your business grows and becomes more complex it can be beneficial to move to the accrual accounting method for either the BAS and tax returns or both even though you haven’t reached the compulsory accrual threshold. Your accountant is best placed to advise you on what accounting method is right for your business and why.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.