‘Cash’ and ‘accrual’ are two different ways of tracking the money side of your business and one will suit your situation more than the other. Let’s start with a simple explanation of each one.

What is cash accounting?

With this system you record income and expenditure events when you get paid and when you pay for something. That’s why it’s sometimes called a ‘payments accounting’ basis. If everything is flowing in and out of your bank accounts, you can just use those records to inform your cash accounting. 

What is accrual accounting?

This system is based on when you create an invoice or complete work, rather than when you get paid; and when you receive a bill, rather than when you actually pay it. So accrual accounting is based on invoices issued and bills received. When you issue an invoice you immediately record that as income. If it doesn’t get paid for some reason, you go back and adjust your income records accordingly. When you receive a bill, or some work you’re paying for is completed, you immediately record it as an expense.

What are the pros and cons of cash accounting?

The main advantage of cash accounting is its simplicity. With your approval, transactions from your business bank and credit card accounts can be automatically sent to accounting software like Afirmo. From there you just allocate each deposit to an invoice or sales category, and each withdrawal to an expense category. 

Cash accounting makes it easy to keep track of your cash flow. It also makes your GST calculations easier, because you will have been paid the GST collected from customers before you have to pay it to Inland Revenue. You can use the cash accounting system for GST if your sales are less than $2 million a year.

The main downside of cash accounting is that it might not give you an accurate picture of how your business is doing at any point in time. For example, you might have several large bills due for payment at the end of the month, but they won’t show in your accounts yet. This can make you think things are going much better than they really are. What’s more, income tax calculations have to use the accrual method, so when you use the cash method you need to make adjustments for unpaid invoices and bills at the end of each financial year.

What are the pros and cons of accrual accounting?

The main advantage of accrual accounting is that it gives you a more accurate picture of how your business is performing, so it’s easier to make well-informed business decisions. For example, if you are working on a long term project for a customer and won’t get paid until it’s complete, accrual accounting lets you record the value of work as it’s delivered, which reveals the true profitability of your business at any point in time. If you have a manufacturing business and the price of raw materials increases, you’ll see that difference in your accounting system straight away. This would allow you to adjust your prices accordingly, before the goods are sold.

The main disadvantage of accrual accounting is its complexity. You have to record the amount of each invoice and bill. However, software services like Afirmo automatically record the value of invoices into your accounts as you create each one.  The other downside of accrual accounting is you might have to pay GST and income tax on some invoices before the customer has paid them. 

Should I use cash or accrual accounting?

Choosing the best system for your situation usually depends on the size of  your business and how frequently you get paid.

Small businesses tend to prefer the simplicity of cash accounting. It lets them keep an eye on their cash flow, and it’s usually quite easy for a small business to take unpaid invoices and bills into account when assessing current performance.

Larger businesses typically prefer accrual accounting. It makes it easier to see changes in their more complex business performance early on and make timely adjustments.  Businesses that don’t get paid for some time, or have irregular income and expenditure patterns, also tend to prefer accrual accounting.

Some larger businesses use a hybrid system, so they always have a reliable up-to-date picture of both their business performance and their cash flow. If an accounting software package has been loaded with both accrual and cash (bank account) data, some will let you switch between the two systems when you need to.

Afirmo is here to help

When you set up your business with Afirmo, or switch to our services, we’ll help you choose the best accounting system for your situation. It’s just one of the ways we remove the complexity of starting up and running a business. Check out our Smarten Up Tools here.