The Difference Between Cash & Accrual Accounting
Accounting explains what’s happening financially within your business. You need to paint an accurate picture of your business activities within a certain period to choose an accounting method that suits your business best. Cash and accrual are the two types of accounting methods used when recording a business’s financial transactions, as well as reporting for GST. Let’s look at a definition of each method, some examples and what the difference is between the two. Cash Accounting The cash accounting method records transactions in periods only when cash is exchanged, received, or paid. This method focuses on cash flow rather than the bigger picture of your financial state. When your invoices are sent or when your products or services are provided isn’t necessarily important. It’s a purely cash-based method of accounting. When accounting for GST using the Cash Method, you only report the GST that has actually been received or paid by your business. You do not report invoices that you have received but not paid or income that you have invoiced for but not received payment. Accrual Accounting Accrual accounting is the recording of transactions when they occur rather than when they are settled in cash. It reports earnings when providing products or services and records your expenses. The accrual method shows an accurate depiction of your business to external and internal users. When accounting for GST using the Accrual Method, you are reporting your GST when invoices have been received by your business, regardless of if they have been paid or not. The same applies for the invoices you send out. You report the GST on these even if they have not yet been paid. Let’s delve into two examples: A Cash Accounting Example Kelly has a small t-shirt stand and uses a cash register. Johnny visits her store and buys a t-shirt. He hands her the money; she gives him the shirt. Kelly records this exchange to keep her cash flow organised. This method works well for Kelly as she is just a small store with small cash sales. In this example, Kelly is best using cash basis accounting. In this example, Kelly would report the GST on her sales (income) as it is received. Suddenly, Jen visits Kelly and wants to buy 40 t-shirts to sell at an event tonight. Kelly agrees to Jen's sale but won't receive payment until after the event. Kelly can invoice this sale, but does not report the GST until the money is received. Now let’s discuss a different type of transaction: Accrual Accounting Example Randy is a skateboard manufacturer who’s designed a new skateboard model. Randy receives a request from a large retailer wanting an order of skateboards totaling $1 million. Using cash basis accounting, Randy will invoice his customers but does not report the GST on his income until the payment is made. Randy received the request on the first of June. It’s now mid-July and Randy’s investor calls him and asks how his sales are going. They invested a lot of money into his business and want to know what’s happening with the numbers right now. Using cash basis accounting there is no income reported on his Profit & Loss, as the invoice issued remains unpaid. Sure, he has cash coming, but not until September because the big retailer said they aren't paying Randy for another 90 days! According to his Profit & Loss, there is no income received. Cash basis accounting is not acceptable in this situation for your investor, because as you can see the income won’t show on the Financial reports until paid. By the time this payment is received, the investor could have pulled out and taken their money elsewhere. When Randy Implements Accrual Accounting Accrual basis recognises the sale and records it, with Randy's investor seeing his expenditure and the large influx of revenue in the same month, showing their correlation. The downside of this, is that Randy needs to report the GST on his sales even though he has not received the income from this yet. The investor is pleased as they see a sale has been made. What’s the Difference? Put simply, the difference is that cash accounting focuses on your short-term cash flow and does not provide a detailed understanding of your finances. Accrual accounting on the other hand shows a comprehensive forecast of your business activities and can help external and internal users better-comprehend how your finances are functioning. Many new or smaller businesses may opt to use cash accounting; however, accrual methods are obviously required among larger operations. For more information on your BAS, you can check out our previous Blog – Preparing Your BAS. Are you a new small business venture seeking a bookkeeper? Contact Ironbark Industries Bookkeeping today to discuss our bookkeeping services, your specific requirements or any other financial management questions or enquiries!