Choosing Between Cash and Accrual Accounting: A Guide for Australian Businesses

As a business owner, it’s important to choose the right accounting method because it can directly impact your tax management and financial reporting. Businesses and accountants commonly debate whether to opt for cash vs accrual accounting. This is because understanding the difference between these two approaches, their tax implications, and how they affect business decisions can be confusing. 

In this guide, we will clarify what cash accounting and accrual accounting are, explore examples of accrual basis vs cash basis, and help you determine the right accounting method for your small business.

What is cash accounting?

The cash accounting method records income and expenses only when you actually receive or pay cash. It only recognises revenue when money physically enters the business bank account and expenses when you make payments. With cash accounting, the advantage is how straightforward the method is.

Example: Imagine a small graphic design business that completes a project in June but only receives payment in July. Under cash accounting, the income from that project is recorded in July when the payment arrives, not in June when the work was done.

If you run a small business where income is derived from providing services based on your knowledge or skill, cash accounting will be appropriate. This is often true for sole traders and businesses set up as partnerships with a low turnover. 

This may be a preferred small business accounting method because it aligns closely with the business’s cash position and tax obligations.

What is accrual accounting?

The accrual accounting method records income and expenses when they are earned or incurred, regardless of when you receive or pay the money. This means that you would recognise revenue upon delivering goods or services and record expenses when the business incurs them, even if payment happens later.

Example: Using the same graphic design business example, the income from the project completed in June would be recorded in June, even if the payment is received in July. Similarly, if the business receives a bill for supplies in June but pays it in July, the expense is recorded in June.

One of the accrual accounting advantages is that you get a more accurate picture of your business’s financial health over time. Larger businesses or those with more complex transactions tend to prefer this method, especially since the law requires them to use it if their turnover is over a certain threshold. 

Difference between cash and accrual accounting

To decide which method is right for you, you’ll need to understand how each one works and their implications. Their differences will impact how your business reports taxable income and how you manage cash flow. 

The table below highlights the key distinctions between the cash accounting method and the accrual accounting method, helping you see how each approach affects your financial picture and business operations.

Aspect	Cash Accounting Method	Accrual Accounting Method
When revenue is recorded	When cash is received	When revenue is earned (invoice date or delivery)
When expenses are recorded	When cash is paid	When expenses are incurred (bill date)
Financial picture	Reflects actual cash flow	Reflects true profitability and financial position
Complexity	Simple and easy to maintain	More complex, requires tracking receivables/payables
Tax reporting	Income and expenses are recognised on a cash basis	Income and expenses are recognised on an accrual basis
Cash flow management	Easier to track the cash available	Better for forecasting and managing future cash needs
Suitability	Small businesses, sole traders, simple finances	Larger businesses, those with inventory or complex transactions

A business using cash accounting might show a profit in one tax year simply because it received payments early, even if it hasn’t completed the work. Conversely, under accrual accounting, the same business would report income only when the work is done, providing a more accurate measure of profitability. 

This difference affects tax liabilities, cash flow management, and business planning.

Advantages and disadvantages of each method

Let’s look at how each method might benefit your business while assessing the cons of each. 

Benefits of cash accounting

One of the primary benefits of the cash accounting method is its simplicity. Because income and expenses are recorded only when cash changes hands, it is straightforward to maintain and understand. 

If you are running a small business that generates income from services based on your knowledge and skills, this might be the right option for you. 

Cash accounting also provides a clear and immediate view of actual cash flow. Since transactions are recorded only when money is received or paid, you can quickly see how much cash is available at any given time. 

Another advantage is lower bookkeeping and accounting costs. Because the method requires less detailed tracking of invoices, accounts receivable, and payable, you can handle their accounts internally or with minimal professional help. 

Additionally, tax management is often simpler under cash accounting, as income is only taxed when received, which can ease cash flow pressures during slower periods.

In summary, cash accounting has the following advantages: 

• Simple to maintain and understand
• Provides a clear view of actual cash flow
• Potentially lower bookkeeping and accounting costs
• Easier tax management as income is only taxed when received

Disadvantages of cash accounting

Despite its simplicity, cash accounting can sometimes give an inaccurate view of a business’s profitability. For instance, if a business completes a large project in June but does not receive payment until August, the income will only be recorded in August. This delay can distort profit reports for both months, making it harder to assess true performance. 

Cash accounting is also not suitable if your business holds inventory or is required by law to use accrual accounting. For example, a retail business with significant stock levels must use accrual accounting to properly match the cost of goods sold with sales revenue.

Moreover, because cash accounting does not account for outstanding invoices or bills, it may not reflect the true financial position of the business. This lack of visibility into cash flow forecasting can complicate business planning and budgeting. 

Overall, these are the cons of cash accounting: 

• Can give an inaccurate view of profitability, especially if payments are delayed
• Not suitable for businesses with inventory or those required by law to use accrual accounting
• May not reflect the true financial position, complicating business planning

Benefits of accrual accounting

On the other hand, accrual accounting offers significant advantages by matching revenue with the related expenses incurred to generate that income. This matching principle provides a more accurate view of profitability over a given period. 

For example, a consulting firm that invoices clients monthly but incurs expenses such as salaries and office rent throughout the month will see a clearer picture of its financial performance using accrual accounting.

This method also provides a more comprehensive financial picture, which is essential for informed decision-making. You can better understand trends, profitability, and financial health, enabling strategic planning and investment decisions.

Most importantly, in Australia, accrual accounting is required by law for certain businesses, particularly those with turnover exceeding $10 million or those managing inventory. 

In short, accrual accounting advantages include: 

• Matches revenue with related expenses, giving a better view of profitability
• Provides a more accurate financial picture for decision-making
• Required by law for some businesses, especially those with turnover above certain thresholds
• Better suited for businesses managing inventory or seeking investment

Disadvantages of accrual accounting

The main drawback of accrual accounting is its complexity. You’ll need to track accounts receivable and payable, manage invoices, and often use more advanced accounting software or professional services. This can be time-consuming and costly, especially for small businesses without a dedicated accounting staff. However, modern cloud-based accounting software has made this more accessible to small business owners.

Another challenge is that accrual accounting may show profits even when cash is low. For example, a business might record significant revenue from sales on credit, but if customers delay payment, the business could face cash shortages despite appearing profitable on paper. This discrepancy can mislead owners about the actual cash available for operations.

Finally, the administrative burden of maintaining detailed records and reconciling accounts can be significant.

To sum up, these are the cons of accrual accounting: 

• More complex and time-consuming to maintain
• May show profits even when cash is low, potentially misleading cash flow status
• Requires tracking of accounts receivable and payable, increasing administrative burden

How to choose the accounting method that’s right for your business

A common misunderstanding is that business owners can just choose the accounting method that they prefer. The ATO has issued a public ruling that makes it clear that businesses must select the method that is most appropriate in the circumstances.? Here are some tips to help you choose the appropriate method according to the ATO’s requirements. 

Nature of the business

Only smaller businesses whose income is derived from services based on an individual’s skill or knowledge, without selling stock or using employees, are considered an appropriate fit for cash accounting. The accruals method is, in most cases, appropriate to determine business income derived from a trading or manufacturing business.   

• Example: A freelance graphic designer operating as a sole trader may find cash accounting perfectly adequate for tracking income and expenses, as their transactions are typically straightforward and involve immediate payments. In contrast, a manufacturing company with numerous suppliers, customers, and a complex inventory system would likely need accrual accounting to accurately reflect its financial position.

Revenue thresholds

Tax law requires businesses with turnover exceeding $10 million to use accrual accounting. This threshold is a critical determinant for many businesses.

• Example: A rapidly growing business surpasses the $10 million revenue mark in a financial year would be legally obligated to switch to accrual accounting to comply with ATO regulations.

Inventory management

Businesses that carry inventory generally must use accrual accounting to properly match costs and revenues. Accurately tracking the cost of goods sold is essential for understanding profitability.

• Example: A retail business selling clothing needs to use accrual accounting to align the cost of purchasing inventory with the revenue generated from selling those items. This approach provides a more precise understanding of the business’s gross profit margin.

Business goals and growth plans

If your business plans to grow, attract investors, or secure loans, accrual accounting provides more detailed financial information that is often preferred by external stakeholders.

• Example: A small software company seeking venture capital funding would likely need to present its financial statements using accrual accounting. Investors typically require a clear picture of the company’s financial health, including detailed revenue recognition and expense matching, to assess its potential.

Consulting an accountant

Given the complexities of accounting standards and tax regulations, consider consulting a qualified accountant who can assess your specific circumstances and recommend the most appropriate accounting method. 

An accountant can provide tailored advice based on your business’s unique needs and help ensure compliance with ATO requirements.

FAQ

Can you switch between cash and accrual accounting?

Yes, businesses may switch between cash and accrual accounting if the appropriate method in the circumstances changes, but it usually requires careful planning and may involve tax implications. 

In Australia, you need to notify the ATO and possibly adjust your financial records accordingly. It’s best to consult an accountant before making the switch to ensure compliance and a smooth transition.

Making accounting work for you

Understanding the tax implications of cash vs accrual accounting is essential for effective financial management and compliance in Australia. Each method has its own advantages and limitations, and the right choice depends on your business’s size, complexity, and goals. 

To ensure full business tax compliance, it’s worth speaking to a qualified accountant to determine the most suitable method for your business.