Cash vs accruals accounting in Free Accounting Software

A lot of business owners are confused by the difference between Cash and Accruals accounting. There are three aspects to this, BAS/GST, Taxation and Accounting.

As you can see from the below explanation, it can get complicated. The best strategy is probably to focus on the BAS where the rules are simple and well defined and get professional advice on the taxation and accounting.

1. BAS (which is really just the GST component)

When you register for GST you can choose whether you account for GST on a cash or accruals basis (if your aggregated business turnover is $10m or more you can't choose cash).

For GST purposes cash means that when the invoice is paid it goes on your BAS. Accruals goes by the invoice date.

Even that is not 100% clear as if the balance of an invoice is transferred to a loan account it considered paid.

2. Taxation

Income is assessable when it is derived. There are 2 main methods, the receipts basis (cash) and the earnings method (accruals). This is all explained in full detail in: TR 98/1 - Income tax: determination of income; receipts versus earnings.

But for taxation purposes you cannot choose which method you use. A quote from the ruling:

"17. When accounting for income in respect of a year of income, a taxpayer must adopt the method that, in the circumstances of the case, is the most appropriate."

You must choose the method that is appropriate. For example, the appropriate method for a salary and wage earner is a receipts basis and for a company it's a virtually always an accruals basis.

For deductions, you can claim the deduction when it is incurred. There is a lot of detail about this in TR 97/7 - Income tax: section 8-1 - meaning of 'incurred' - timing of deductions

3. Accounting and financial statements

From an accounting perspective there are yet other rules. Some consideration here is what accounting standards are being applied. Most/all small businesses would not prepare general purpose financial statements (this is the kind a public company prepares).

The financial statements of most small businesses is therefore simply based on generally accepted accounting principles. It's based on philosophical ideas like what is an asset, liability, income, expense etc.

When you get income you receive cash so we Debit Cash and Credit Income. If you sell something on credit we Debit Accounts receivable and credit income and later when the cash is received we Debit Cash and Credit Accounts receivable.

You cannot have a Debit without a Credit and the value of the transaction is the amount paid or received (historical cost).

Sometimes a small business owner will ask I'm on a cash basis why is this income showing in my Profit and Loss statement which I have not yet received. Well the answer is that it is an income and Profit and Loss is not Cash Flow (there is a separate statement for that, that no one bothers preparing). Also you cannot have the Accounts receivable in the balance sheet without the Income, because for each Debit there is a Credit.

It should be noted here that accountants for small business would be loathe to create a difference between taxation and accounting treatments because of the confusion it would generate. However, there are some differences like superannuation that are generally recorded.

Example 1. Superannuation

Superannuation is only a tax deduction when paid and only if paid on time. They've set a law for that. Doesn't matter if you're on cash or accruals.

However, in your financial statements the expense will likely be shown and the corresponding amount payable will be in the balance sheet (unless you paid it before 30 June to get the deduction, if so well done).

Example 2. Asset purchase

On 1 June you buy an asset and get the invoice. It gets installed on 1 June and you start using it. You don't pay until 1 July and your BAS/GST is on a Cash basis.

For the period ended 30 June:

BAS/GST: You can't claim the GST because you didn't pay it.

Tax: Using the simplified depreciation rules you can put it in the General pool and claim 15% or if below the threshold claim an immediate deduction.

Accounting: You would expense 1 months depreciation of the useful life of the asset.

Example 3. Sole trader consultant income

As per paragraph 44 of TR 98/1 - Income tax: determination of income; receipts versus earnings a consultant operating as a sole trader invoices the client on 30 June for work done in the last week of June. The invoice gets paid in July and the consultant is registered for GST and uses the cash basis.

BAS/GST: Does not have to pay GST on the BAS until the September BAS as has not received the cash as at 30 June.

Taxation: No income based on the circumstances of para 44 being a knowledge worker and set up as a sole trader the receipts basis is used.

Accounting: The amount receivable is an asset and the income is earned so the income includes this figure.

It should be noted that the fact that the business owner is recording accounts receivable, i.e. keeping records on an accruals basis is something that pushes it in the direction of the income being taxable on an accruals basis. If you think about it, it's a bit weird to think that you'd produce financial statements on an accruals basis and then claim that it was not a substantially correct reflex of your income.