Which is better – cash accounting or accrual accounting? And what about hybrid accounting?
If you’re a Small Business Owner, or are thinking of starting up your own business, then you may be wondering which accounting method is better for your business.
In this blog, we’ll uncover the differences between cash and accrual accounting and the benefits of each, as well as hybrid accounting and how you can zone in on the right accounting method for you.
The difference between cash and accrual accounting
The main difference between these two methods is when payments and expenses are recorded. Cash accounting records transactions when money exchanges hands. Accrual accounting records transactions based on anticipated incomings and outgoings. Both of these methods have pros and cons.
What is accrual accounting?
Accrual accounting is a method of accounting that records payments and expenses when they are noted as occurring, rather than when payment is actually received or paid. The benefit of accrual accounting is that it allows current cash inflows and outflows to be combined with expected cash inflows and outflows. This gives a company a more precise outline of their current financial position.
For most companies, accrual accounting is standard practice.
The benefit of accrual accounting is that it allows a company to get an overall idea of their financial position.
Here’s an example of accrual accounting: Let’s say you own a medium-sized business that has a large expense coming up – you need to pay your supplier $14,000 for the latest delivery of goods. However, you also have a number of orders that have been placed and will be billed before the date you need to pay the supplier. The money that currently exists in the business, as well as the upcoming payments from clients, will more than cover the payment to the supplier. Therefore, when you calculate your finances using the accrual accounting method you can see that the company is in a profitable financial position even before any money has exchanged hands.
What is cash basis accounting?
Cash accounting is a straightforward accounting method where payments and expenses are recorded at the time they’re received or paid. In other words, transactions are recorded only when they go in or out.
This is often a good accounting method for small businesses, but does not work as well for larger organisations as it can make the true financial position unclear. This is because there can sometimes be a delay between when an order is placed and when the payment is actually made.
For example, let’s say you own a cake making business. Someone makes an order for a wedding cake on 10 June, but full payment is not actually received until the following month on 1 July. If you were using the cash accounting method then the transaction would not be recorded until 1 July, as this is the day that money exchanged hands regardless of the fact that the order was made on 10 June.
The biggest benefit to cash accounting is that it’s simple and straightforward. It allows you to see exactly how much cash you have on hand at the time. It deals in concrete, known quantities. It can make calculating GST easier.
However, the ATO has certain rules around which businesses can and cannot use cash accounting. If you’re unsure about anything, you should speak with your Accountant or Financial Advisor.
What about hybrid methods of accounting?
Hybrid accounting takes a little from column A and a little from column B, combining both accrual and cash accounting.
Some businesses may use accrual accounting for large transactions, like business loans, and use cash accounting for normal, everyday transactions. However, like cash accounting, there are certain rules around what types of businesses are allowed to use hybrid accounting in Australia.
Cash vs accrual: what is the best type of accounting for small business?
Whichever accounting method you choose for your small business will affect your bookkeeping and tax filing. If you run your own small business and make less than $10 million a year (as well as a few other requirements), you can choose between cash, accrual or hybrid accounting.
The best type of accounting method for you will depend on the kind of business you run, what line of work you’re in and how many employees you have.
Have a look through this checklist and see which method looks like it will suit your business best.
1. What is the current size of your business?
If you’re a Sole Trader then cash accounting might be a simple and easy way for you to manage your finances. But if you already make more than $10 million per year then you’ll have to use accrual accounting according to the rules set out by the ATO.
2. What are your plans for the future of your business?
Are you planning to grow your business? If you’re thinking of expanding the size of your enterprise, then accrual accounting may make things easier for you in the future – especially if you plan on building your profits so that they exceed $10 million per year. Whether or not you intend to hire on employees will also affect this decision.
3. Are you planning on bringing investors into your business?
Accrual accounting is an accurate and transparent way to show investors how much money your company is making. Cash accounting does not provide as precise a picture, and if you’re thinking of bringing in investors or applying for a large loan, accrual accounting may help your case.
How can you take the headache out of accounting for your small business?
There are so many reasons to start your own business – but when you’re dreaming of becoming your own boss, or following a lifelong dream, how you manage your accounts probably isn’t at the top of your list.
That’s OK. Numbers aren’t everyone’s favourite thing, even when they’re showing you how profitable your business is!
Xero online cloud accounting software is one of the best small business accounting software programs available, and it can help make doing your accounts simpler – whether you choose to use cash accounting or accrual accounting.
Open Colleges has teamed up with The Career Academy to bring you the Certificate In Xero short online course. This course will teach you all the basics of Xero so you can get the most out of this cloud-based accounting software, and avoid an accounts-related headache.
Enrol today and start studying.