Often, small business owners are confused whether to choose cash-basis accounting or accrual accounting for recording their transactions. Larger businesses (turnover more than $2 million) have to use accrual accounting for GST purposes, but smaller businesses have a choice. Both methods have advantages and disadvantages, so it is up to the individual business owner to study the implications and make an informed decision.
This is definitely the simpler of the two methods for small businesses, as transactions are recorded when cash actually changes hands. Your business income and expenses are recorded when they are paid, not when you issue or receive an invoice.
This method gives a good idea of actual cash flow, but when it comes to matching revenue generated with expenses, cash accounting does not give an accurate picture. For example, if you buy products during one month and sell them during the next months, you do not get the correct financial picture through cash accounting.
Here, income and expenses are recorded when you receive or issue an invoice, not when the bill is actually paid. You get a better picture of your credit and debt and thus, better insight into the financial state of your business. Monitoring your debts is very important in today's economic environment to avoid being in a bad financial position. Accrual accounting also allows you to analyse the current financial trends so that you can estimate the future sales revenue and expenses.
Accrual accounting has the drawback that revenue is being tracked and not actual cash. For small businesses with less cash flow, this can prove difficult if your customers are a bit slow to pay. You might end up with a great income statement, but little actual cash. To avoid this situation, you can additionally monitor the weekly cash flow to ensure that you have enough cash to run the business.
Which method is better for GST purposes?
It is easier to manage cash flow when you are using cash accounting for GST, as your activity statements and actual money flow aligns closely.
When using the accrual method, GST is payable on all sales for which you have received an invoice during the period, even if you have not received the actual payment. But on the other hand, you can also claim GST even on unpaid expenses upfront. So for large purchases, you have an advantage when you claim GST when you first get the invoice.
For taxation purposes
For taxation purposes, many businesses choose cash basis reporting, even if they use accrual accounting otherwise. Service based businesses might be better off choosing cash method while trade or manufacturing businesses might benefit from the accrual method.
It is up to you as the business owner to choose the accounting method that is most appropriate for your business. If it is simplicity you want, choose cash accounting, but if you want to better understand the financial status and do some revenue projections, accrual accounting is the better option.