Many small business owners record their transactions using cash-basis accounting, but could the accruals method be more appropriate? Learn the difference so you can make better accounting decisions for your business.
Cash vs. accruals accounting often confuses clients, as either method can be used for different purposes, such as tax, GST or overall accounting. Business owners need to understand the difference and be aware of the implications of each method to decide which approach is best for their business.
Difference between cash and accrual accounting
Cash accounting is recognising the income and expenses in your business when they are physically paid rather than on receipt or issue of an invoice. Many business owners when starting out often use a simple, basic cash system, because it helps to keep track of cash flow.
An accrual accounting system recognises both income and expenses on receipt of an invoice or bill although not yet due for payment. This system will create debtors and creditors in your accounting software, showing what you owe and when, as well as funds owed to the business from your customers. In today’s tough business environment it is more important than ever to monitor your debtors closely and have a good system in place to reduce the number of days awaiting payment or, worse still, avoid it becoming a bad debt that has to be written off.
The benefits of accrual accounting
I believe there are greater benefits for small business owners of using the accrual accounting method. Not only does it help them understand their business better by highlighting their true financial position, but, more importantly, it highlights the cash-flow effects of collecting debtors and paying creditors.
To see these benefits it helps to compare your business situation to a personal one.
Consider this: When it comes to your household utilities, when do you recognise your debt? Is it when you receive the electricity or telephone bill; is it on receipt of the invoice, or is it when you pay bill?
In the context of your personal accounts, it makes sense to recognise the debt when the bill arrives to help you keep track of money that you have and don’t have, no matter the account figures. The same goes for your business accounts.
Implications of accruals for GST
Small businesses whose annual turnover is less than $2 million and greater than $75,000 are able to choose to register for GST on either a cash or non-cash (accrual) basis. Businesses with a turnover greater than the threshold must account for GST on a non-cash (accrual) basis while businesses with a turnover less than $75,000 are not required to register for GST but may choose to do so.
How you choose to register for GST may greatly affect the cash flow of your business, as GST is payable on sales for which payment has not yet been received, This could leave you out of pocket for a time. However, GST can also be claimed on unpaid expenses if you hold a tax invoice.
Whether you’ve registered for GST on a cash or accrual basis will also affect your financing of large purchases for your business. With accruals, GST is claimable upfront, so it might be of benefit to your business to use this method.
This is probably the touchiest topic as no one wants to pay the taxman more than they have to. Again, many businesses may report for taxation purposes on a cash basis even if they process their accounting as accruals. According to the ATO Taxation Ruling TR 98/1, the accounting method adopted for income tax purposes should be the most appropriate for the business. The receipts or cash method is likely to be more appropriate for businesses providing a skill or service, whereas the earnings or accruals method may be more appropriate for trading or manufacturing businesses.
Discuss with your tax accountant which is more appropriate and beneficial for your business.
Which method do you use for accounting, tax and GST in your business, and why?