When it comes to managing your business’s finances, one of the first and most important decisions you’ll make is choosing the right accounting method. For lots of small businesses here in Australia, this will boil down to one comparison in particular: accrual accounting or cash accounting. Both methods come with their own pros and cons, and the best fit will ultimately depend on your business model, stage of growth, reporting needs, and other considerations.
So let’s take a look at some of the core differences between cash basis accounting and accrual basis accounting, explaining how each one will influence your financial reporting and why one method might be better than the other for your business.
Understanding the difference
The biggest difference between the cash method and the accrual method of accounting lies in when you record transactions.
- Cash accounting (or the cash basis method) records income when it’s received and expenses when they’re paid. If you invoice a client in April but don’t get paid until May, for example, then the income is recorded in May.
- Accrual accounting (or the accrual method) records income and expenses when they’re earned or incurred, regardless of when the actual payments are made. In the same situation as above, the April invoice would be recorded in April, even though the payment didn’t arrive until May.
What is cash basis accounting?
Cash basis accounting is most often used by sole proprietors and very small businesses (i.e. micro-businesses). It only accounts for money when it changes hands, so it gives you a real-time snapshot of cash that’s available.
Because it’s so simple, the cash method is easy to manage for businesses without lots of inventory or receivables. It can also give you some short-term tax advantages – since you’re only taxed on income when it’s received, you can time your payments and income to lower your tax burden in a given tax year.
But this method can also give a misleading view of your business’s financial health. Say you provided services worth $50,000 in a month but only received $10,000 in that period. On paper, cash accounting shows just $10,000 in revenue – ignoring the money owed.
Cash accounting also doesn’t track accounts receivable or accounts payable, which can make it harder to manage your liabilities and plan for the future. While it works for lots of small businesses, it might become a hassle as your operations expand.
What is accrual accounting?
Accrual accounting takes a more holistic approach. It recognises income when it’s earned and expenses when they’re incurred, not necessarily when the payment happens. So you end up getting a far more accurate picture of your company’s financial performance.
Under the accrual system, you’ll track accounts receivable and accounts payable, which is easier for managing liabilities and forecasting your future cash flow. The method also aligns with the generally accepted accounting principles (GAAP), which is important for businesses that want to scale up or present their financials to investors.
One important downside? You might end up having to pay taxes on income before it’s actually received. If you invoice $20,000 in June but your client doesn’t pay until August, for example, then the ATO will consider that income for June. If your client doesn’t pay at all, reclaiming the taxes paid on that income can be time-consuming and stressful.
Still, for many growing businesses, the accrual accounting method is far more transparent and can help you make better decisions around scaling.
A practical example of cash and accrual accounting
Imagine a gardening business completes $30,000 of work in March and invoices all of their clients on the 31st, with 30-day terms for payment.
- If the business uses cash basis accounting, it only records income once the money is received. So if only $5,000 of invoices are paid in March, that’s the reported income.
- If it uses accrual basis accounting, the full $30,000 is recorded as income for March instead.
While the cash basis shows available funds, the accrual method shows actual business activity. It might not seem overly important now, but such a distinction becomes much more important as your business grows, especially if you’re dealing with larger contracts or deferred payments.
Tax implications
Your choice between cash or accrual accounting has a big impact on how and when you pay taxes. With cash accounting, your tax obligations are based solely on actual payments received during the financial year. With accrual accounting, you’re taxed based on earned income – regardless of when the cash comes in.
For small businesses that want to defer tax or manage tight cash flow, the cash basis method might give you more flexibility in the short term. But if you deal with large volumes of invoicing or need to keep detailed financials for funding, accrual accounting will probably be the more strategic choice.
Keep in mind that if your business earns more than $25 million in annual turnover, you’re required to use the accrual accounting method under GAAP standards.
Which method is best for your business?
Lots of small businesses start with the cash basis because it’s the simplest tool, then switch over to accrual accounting as their business grows and their reporting needs become much more complex. Here are a few situations that might help with your decision:
- If you’re a freelancer or sole trader with few overheads and no inventory, cash basis accounting could be all you need.
- If you run a product-based business with inventory, manage supplier invoices or provide services on credit, accrual accounting is likely a better fit.
- If you plan on getting a business loan or want to attract investors, having the most accurate picture of your finances via the accrual method is a must.
Before deciding, it’s worth getting professional advice from an accountant or tax agent, as they can help you weigh up the differences between accrual and cash basis accounting and how each would affect your business’s balance sheet and tax obligations.
See related terms
What are assets?
What is capital?
What is accounting?
