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Forecasting – Cash vs Accrual and the benefits of both
Ever wish you could look at your business in different ways to get a different perspective?
Enter the Cash & Accrual Accounting methods.
These two different methods for recognizing your transactions are the two most popular ways for business owners to look at financial performance.
We cover their different aspects and outline why each might be useful for your reports & projections below.
This is usually the default way of reporting when using platforms like Xero or Quickbooks for your accounts.
Accrual accounting essentially recognizes income per date on the invoices or bills rather than the date of payment. The accounting explanation is that the invoices or bills are recognized in the accounts when the obligation is incurred.
This is usually most relevant in service-based businesses with large accounts receivable (i.e. agencies) or any other business or accounts payable (i.e. businesses carrying inventory).
By adopting an accrual approach, the business owner can see the Profit & Loss report based on invoices featuring per their invoice date. This often can lead to smoothing out of ongoing expenses, particularly where monthly invoices are accumulated and then paid out as a lump sum.
Cash accounting revolves around the activity in the company bank account.
In other words, bills and invoices aren’t on record until they are paid.
This is often the approach by smaller businesses which are often not inputting invoices separately in Xero but rather just reporting the activity from their bank statements. This is sometimes discussed as ‘cashbook accounting’ as well.
This is the approach for a lot of online marketplaces, tradespersons and early stage businesses.
The ATO allows cash accounting for businesses earning less than $20 million across their GST reports (i.e. BAS). Businesses might opt for this method of reporting where they have logged plenty of invoices which haven’t been paid yet. The benefit here for founders is that the tax payable is calculated on banked income – which is obviously easier to pay.
Forecasting under the Cash vs Accrual basis
Startups are often more interested in forecasts prepared on a cash basis since this more accurately reflects the bank balances at any given time. This allows founders to better project cashflow requirements on a month to month basis and adjust their activities accordingly.
Established large businesses with many investors and lenders are more often required to prepare forecasts on the accrual basis which is more in line with the general accounting principles. Basically, this is the theme that expenses should be recorded when an obligation is incurred rather than paid.
Businesses producing profit & loss reports and forecasts need to understand the difference between cash & accrual reporting and when to apply them. If in doubt, reach out to a good accountant to lead you in the right direction.