Occasionally, Glint Accountants receive calls from concerned business owners who request for an explanation of what cash and accrual accounting means. This usually occurs when their business needs to be registered for Goods & Services Tax (GST) and they are required by ATO to choose an accounting method for GST.
There are two methods of accounting for GST – on a cash basis or a non-cash basis (accruals).
Basic Difference between Cash and Accrual Accounting
To put it simply:
Accounting on a cash basis means recording income and expenses when the cash transaction happens.
Accounting on an accrual basis means recording income and expenses when they are incurred or delivered, without taking into consideration when payment is received or made. This is usually when credit terms are available.
Yyou engage a web developer to create your website for $2000 to be paid in 4 weekly instalments of $500.
Cash Accounting: Each payment of $500 is recorded as an expense when paid.
Week 1: $500 expense recorded when paid; bank account reduced by $500
Week 2: $500 expense recorded when paid; bank account reduced by $500
Week 3: $500 expense recorded when paid; bank account reduced by $500
Week 4: $500 expense recorded when paid; bank account reduced by $500
Accrual Accounting: The expense of $2000 is recorded with corresponding $2000 owing to the web developer as an accounts payable. Then as each $500 payment is made, the accounts payable is reduced.
$2000 expense recorded when web developer is engaged with corresponding record of $2000 in Accounts Payable
Week 1: $500 payment reduces Accounts Payable; balance owing is $1,500
Week 2: $500 payment reduces Accounts Payable; balance owing is $1,000
Week 3: $500 payment reduces Accounts Payable; balance owing is $500
Week 4: $500 payment reduces Accounts Payable; balance owing is $0
Cash Basis of Accounting
What are the advantages of cash method of accounting?
- Simplicity – The cash basis of accounting is the simplest method as it is familiar to most people. It’s easy to determine when a transaction has occurred ie. when the money is received into the bank account or paid out of the bank account. There is also no need to track accounts receivables or accounts payables.
- Easy to Track and Understand – The cash basis of accounting is beneficial in terms of tracking how much cash the business actually has at any point in time. All you have to do is to look at your bank balance and you’ll know instantly how much cash you have at your disposal.
- Taxed on actual funds available – Since transactions aren’t recorded in the books until the cash is received or paid, the profit is not taxed until the net funds are available in the bank account.
What are the disadvantages of cash method of accounting?
- Inaccurate picture – The cash basis of accounting may paint a biased picture of your profit and loss because expenses and revenue are often recognised in different periods. You may have purchased stock in October in anticipation of demand in the run up to Christmas. So in October, there is a net loss with no corresponding revenue for that stock purchase, while in December, there is a huge profit due to Christmas sales with no corresponding expense for those sales.
- Does not aid in management/strategic decisions: This method of recording income and expenses does not provide the business owner with the ability to perform meaningful financial analysis of the performance of the business as the profit margins and cashflows are often skewed in the books.
Accrual Basis of Accounting
What are the advantages of accrual method of accounting?
- Accurate records – The accrual basis of accounting matches income and expenses to the appropriate period. Therefore, it provides a clear and more reliable picture of the performance of the business. Let’s use the earlier example of stock purchased in October in anticipation of Christmas demand. In October, the purchase will be recorded as inventory (ie. asset). In December, when the sales are made, the inventory quantities and values are transferred from asset to expense. Therefore, sales and expenses will be evenly matched and the corresponding profit and profit margin is an accurate representation.
- Compliance with accounting standards and principles – With accurate matching of sales and expenses in each financial period, the accrual method results in financial statements that are unaffected by cash timing and more acceptable to prospective business investors.
- Easy of planning – With sales and expenses correctly reflected in the right financial periods, a business owner will be able to create budgets and forecasts, which is essential for planning for stock levels, staffing and other areas of operation.
What are the disadvantages of accrual method of accounting?
- More difficult to determine working cash flow – The accrual method makes it more difficult to know how much cash your business actually has available. You will need to adjust it with accounts receivables and accounts payables in mind, along with any GST or taxes owing to ATO.
- More discipline required – The accrual method requires a business owner to be disciplined and record expenses immediately when invoices are received from suppliers, rather than when paid.
- May be taxed on profits before funds are available – Since transactions are recorded in the books before cash is received or paid, the net profit is taxed even before funds are available in the bank account.
A company may look profitable but may experience a major cash shortage in the short term due to high accounts receivables.
If your business is using the accrual method for GST purposes due to having a turnover of above $10 million, you may wish to consider our virtual CFO services. which will help you to determine where your business is currently at, and provide you with clarity to get to where you would like your business to be.
Cash and Accrual Accounting: Where could things go wrong?
Excel spreadsheets: It is common for start-ups to use Excel to track income and expenses. While the bank statement is a good starting point, relying on the bank statement would usually result in cash basis of accounting. If you wish to have an accurate representation of your business finances, be sure to include sales invoices and supplier invoices (bills) in your spreadsheet even if the transactions don’t appear in your bank statement as yet.
Accounting software: Check the financial settings in your software to ensure that matches your selected GST reporting method. If in doubt about your GST reporting method, refer to a previously lodged BAS, contact ATO for clarification or seek assistance from your accountant/bookkeeper to ensure that these settings have not been overlooked.
Disclaimer: This blog post has been simplified to explain cash and accrual accounting methods in layman terms. This should not be construed as advice from Glint Accountants. Therefore, we encourage readers of this blog post to contact Glint Accountants for further assistance.
Prefer to speak to someone about your business performance and finances? Contact us at Glint Accountants to make an appointment to go through your accounting records today.