In Accounting, there are two methods of that are widely used: cash basis and accrual basis (or non-cash). Each method has its own set of advantages and considerations, making it crucial for businesses to understand their differences and choose the most suitable approach. Let’s explore into the comparison between cash and accrual accounting in this article.
The amounts you include in your assessable income and expenses each year depends on the method you choose. You need to be consistent with the method you use for all transactions each year using the same method.
Cash Basis Accounting
Cash basis accounting is straightforward: transactions are recorded only when cash actually changes hands. This means income is recognized when it’s received, and expenses are recorded when they’re paid. It’s a simple method that provides a clear picture of the actual cash flow within a business. For small businesses, freelancers, or sole proprietors, cash basis accounting can be an attractive option due to its simplicity and ease of use. It’s also the preferred method for tax purposes for many small businesses in Australia.
When you’re managing your assessable income on a cash basis, here’s what you need to do:
- Include in your income any payments received each financial year, regardless of whether the work was completed in a different financial year.
- Exclude any amounts for work that was completed, but you did not receive payment during the financial year.
The cash accounting method can be used if any of the following conditions are met:
- Your business is a small entity, meaning it’s an individual, partnership, trust, or company with a combined turnover of less than $10 million.
- You’re not operating a business, but your enterprise’s GST turnover is $2 million or less.
- You use a cash basis for income tax accounting.
- Your enterprise is of a type that we’ve agreed can use cash accounting for GST, regardless of your GST turnover.
Advantages of Cash Basis Accounting:
- Simplicity: Cash basis accounting is easy to understand and implement, making it suitable for small businesses with limited accounting resources.
- Cash Flow Focus: Since transactions are recorded based on actual cash movements, cash basis accounting provides a real-time view of cash flow.
- Tax Benefits: Small businesses may enjoy tax advantages with cash basis accounting, as they only pay taxes on income received, not income invoiced. This makes it easier to manage cash flow.
Disadvantages of Cash Basis Accounting:
- Limited Insight: Cash basis accounting may not provide an accurate picture of a business’s financial health, as it doesn’t account for income and expenses that have been invoiced but not yet paid.
- Timing Mismatch: It can lead to timing discrepancies, especially for businesses with significant accounts receivable or accounts payable.
Accrual Basis Accounting
Accrual basis accounting, on the other hand, recognizes income and expenses when they’re incurred, regardless of when cash is exchanged. This method provides a more accurate representation of a business’s financial position by matching revenue and expenses to the period in which they occur. Larger businesses, corporations, and entities that require a more comprehensive view of their financial performance often opt for accrual basis accounting.
When you’re using the accruals method to figure out your income, you include all the money you’ve earned from work you did in the financial year. This is true even if you haven’t been paid for the work by the end of the year.
Advantages of Accrual Basis Accounting:
- Accurate Financial Reporting: Accrual accounting provides a more accurate reflection of a business’s financial position by matching income and expenses to the period in which they’re earned or incurred.
- Better Long-Term Planning: Businesses can make more informed decisions about future investments and expenses based on accrual accounting’s comprehensive view of financial performance.
Disadvantages of Accrual Basis Accounting:
- Complexity: Accrual accounting can be more complex and time-consuming to implement compared to cash basis accounting, requiring careful tracking of accounts receivable, accounts payable, and adjusting entries.
- Cash Flow Discrepancies: Since income and expenses are recorded when incurred, rather than when cash changes hands, there may be discrepancies between reported financial results and actual cash flow.
- Tax Challenges: Accrual accounting may result in higher tax liabilities, as businesses are required to report income as it’s earned, regardless of when payment is received.
Accounting method for BAS and GST
Determining the appropriate method is important for BAS (GST and PAYG) purposes. The method you choose will affect the timing and value of the GST you must report.
If your business has a combined turnover of less than $10 million, or if you use cash accounting for income tax, you can choose either method.
However, most larger businesses must use the non-cash method.
Businesses that use cash, accounting, or simplified accounting methods can still qualify for Simpler BAS reporting if their GST turnover is under $10 million.
Choosing the Right Method:
Ultimately, the choice between cash and accrual accounting depends on various factors, including the size and nature of the business, regulatory requirements, and management preferences. Small businesses with straightforward financial transactions may find cash basis accounting sufficient, while larger enterprises with complex operations may benefit more from accrual basis accounting.
In Australia, businesses should also consider the requirements of the Australian Taxation Office (ATO) when selecting their accounting method. While cash basis accounting may offer tax advantages for some small businesses, others may be required to use accrual basis accounting for tax reporting purposes.
Regardless of the chosen method, it’s essential for businesses to maintain accurate and up-to-date financial records to ensure compliance with regulatory standards and make informed strategic decisions.
Consulting with a qualified accountant or financial advisor can help businesses navigate the nuances of cash and accrual accounting and choose the method that best suits their needs and objectives in the Australian business landscape.
How to change accounting methods
If you’re eligible to switch accounting methods, speak with your accountant on how to notify the ATO.
The transition from the cash method to the non-cash method can only begin on the first day of a tax period (i.e. the new financial year).
During the first tax period after the switch, you’ll need to account for any sales or purchases that you haven’t previously accounted for or claimed.
This implies that in the first tax period when you use the non-cash method, you’ll need to:
- Report the GST on any sales for which you had issued invoices prior to the change date but haven’t received payment yet.
- Account for the remaining GST on any sales that were partially accounted for before the change.
In that first tax period, you’re also eligible to claim any unclaimed GST credits for which you hold a tax invoice.
Get in touch with our team at Blackwattle we can help assess your options and get you back on track to healthy operations.
Blackwattle Tax has a team of experienced Chartered Accountants that are ready to support you and your business. We have help countless families and businesses make informed decisions that have resulted in better financial and tax outcomes.
To find out how we can help you with your strategic business decisions, book a free consultant with us.
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Disclaimer: We endeavour to make sure the information provided in this guidance is up to date and accurate. Please note, that the information is only intended to be a guide, with a general overview of information. This guidance is not a comprehensive document and should not be interpretated as legal advice or tax advice. The information is general in nature. You should seek the assistance of a professional opinion for any legal and tax issues related to your personal circumstances.
