10 financial concepts you should master
Over the next 10 segments we will be unwrapping essential financial concepts and how they will help you run your business.
Cash accounting versus accrual accounting
Essentially the difference between cash accounting and accrual accounting is the way debits and credits are accounted for in the book-keeping process.
Cash accounting is a system where you account for your profitability based purely on the movement of cash in and out of your business – it’s cash in, cash out and what’s coming in and out of the bank account (plus any cash on hand). It’s that simple.
Revenue is recognised only when cash is received and expenses are recognised only when cash is paid out.
Cash accounting does not recognise promises to pay. It’s a system that works very well for small businesses like hair dressers and personal trainers who are receiving cash for their services and are in turn paying cash to their suppliers.
The ATO allows cash accounting for those small micro businesses because it is simpler from a record-keeping point of view.
Accrual accounting is completely different. Accrual accounting allows you to account for expenses that have been incurred but not yet paid for (accounts payable) or income that has been earned but which has not yet been received (accounts receivable). The money is not yet in the bank account, it’s just a promise to pay.
For example, if you send out an invoice to a client for $2000 and that client takes 60 days to pay, you can count that money as revenue even though the cash has not yet arrived in your account.
Accrual systems recognise revenue that is technically earned but has not yet been received and records expenses whether or not they have been paid.
You are making adjustments each month for your debtors and creditors and inventory. When revenue is recognised before cash is received it is recorded in a debtors account. When an expense is recognised before cash is paid it is recorded in a creditors account.
So which system is better?
Accrual accounting is more technically correct because it gives you a better understanding of your business and the timing impact of cash flow and the operations of the business.
It is possible, for example, to have a business that is profitable but which has negative cash flow. Accrual accounting would pick that up.
The accrual method provides a better picture of how the business is going, how many sales you have completed and what expenses you need to pay. The cash method gives a better picture of how much cash you have on hand.