What Is Accrual Accounting? A Guide for Australian Small Business

Accrual accounting records income when you earn it and expenses when you incur them, whatever the bank account is doing. Cash accounting waits for the money to move.

That is the whole idea. The complications come from what most explanations leave out: accrual is not one decision. It is three separate ones, and they can land differently. How you keep your books, how you report GST and how you work out taxable income are settled under different rules, and being on accruals for one does not put you on accruals for the others.

Earned, Not Received

Revenue is earned when you have done the thing you were paid to do. The job is finished, the goods have left the shelf, the month of the service contract has passed. That moment is what accrual accounting records, and it is usually some distance from the moment the money arrives.

Expenses work the same way in reverse. The electricity you burned in June is a June expense, even though the bill turns up in July and you pay it in August. The subcontractor who worked on a job in March is a March cost, whenever you settle with them.

Cash accounting ignores all of that and follows the bank feed. Money in is income on the day it lands. Money out is an expense on the day it leaves. It is simpler, and for a one-person business that invoices and gets paid on the spot, the two methods give almost the same answer.

They diverge the moment there is a gap between doing the work and being paid for it, which for most businesses is always.

The Same Month, Two Ways

A small creative agency in Melbourne finishes a branding project in March and invoices $10,000 on 28 March, on 30 day terms. A freelance designer who worked on the job bills the agency $2,000 in March, payable in April. The client pays in late April. The agency pays the freelancer in April.

Both methods report $8,000 of profit across the two months. Neither is wrong. They answer different questions, and the question accrual answers is the one you need when you are trying to work out whether a month was any good.

The difference matters more the lumpier your work is. A builder with three jobs a year, a consultant with a single large retainer, a business that does most of its trading in the run-up to Christmas: on a cash basis their reports look like a series of spikes and empty months that have very little to do with when they were busy.

The Matching Principle

The reason accrual accounting produces a useful profit figure is not really the timing of revenue. It is that costs get pulled into the same period as the income they helped earn. That idea has a name, the matching principle, and it is what makes a monthly profit figure mean something.

If the $10,000 of revenue sits in March and the $2,000 of subcontractor cost sits in April, March looks unusually profitable and April looks like a loss. Neither is true. Matching the two puts them together where they belong.

It is also why some costs get spread rather than recorded in full. Annual insurance paid in July is not a July expense of $6,000, it is $500 a month for twelve months, because that is how the cover is used. A $9,000 machine is not a $9,000 expense in the month you buy it, it is depreciation across the years it earns money for you. Prepayments and depreciation are both the matching principle doing its job.

Two New Accounts

Recording income before the money arrives means you need somewhere to hold it. That is what accounts receivable is: invoices issued and not yet paid, sitting on the balance sheet as an asset because the money is owed to you.

Accounts payable is the mirror image. Bills received and not yet paid, sitting as a liability because you owe them.

Modern accounting software creates both entries for you. Raise an invoice and it books revenue and receivable in one step. Enter a supplier bill and it books the expense and the payable. You do not do journals by hand. What you do have to do is keep the two lists honest, because they are where accrual bookkeeping goes wrong in practice.

• Receivables that are never going to be paid. An invoice from fourteen months ago that the client disputed and you gave up chasing is still sitting there inflating your assets and your reported income. It needs to be written off.
• Bills entered twice. A supplier invoice keyed in manually and then imported again from a bank feed becomes two expenses and one phantom payable.
• Payments not matched to the invoice. Money arrives, gets coded straight to income, and the original invoice stays open. Now the income is counted twice and the receivable never clears.

None of these are exotic. They are the ordinary result of a busy month, and they are the reason an accrual set of books needs a reconciliation habit that a cash set does not. Our guide to setting up a chart of accounts covers the structure that makes this easier to keep clean, and the difference between bookkeeping and accounting explains who normally does which part.

GST Is a Separate Choice

This is where a lot of published advice is simply wrong, including advice that sounds confident. You will read that registering for GST puts you on the accruals method. It does not.

If your aggregated turnover is under $10 million you can choose to account for GST on a cash basis, and plenty of small businesses should. The choice is also open, regardless of turnover, to entities that account for income tax on a cash basis, to ATO endorsed charities and deductible gift recipients, and to government schools.

The difference is not academic. On the non-cash method you remit GST on an invoice in the quarter you issue it, whether or not the client has paid. On 30 day terms and a slow payer, that means handing the ATO a tenth of an invoice you have not collected.

The two methods work like this.

• Cash basis. GST on a sale goes on the activity statement covering the period you receive the payment. GST credits on a purchase go on the statement covering the period you pay for it. Your BAS follows your bank account.
• Non-cash, or accruals, basis. GST on a sale goes on the statement for the period in which you issue the invoice or receive any payment, whichever happens first. Credits follow the same rule for purchases. Part payments count, so a deposit brings the whole sale into that period.

Cash basis for GST is one of the small business concessions that comes with the under $10 million turnover test, alongside several others worth knowing about. We cover the full set in our guide to small business tax concessions. If you are not registered yet, whether to register for GST is the earlier question.

You can keep your books on accruals and report GST on cash. Good accounting software handles both and will produce either version of the BAS from the same ledger. That combination is common and often the right one: accrual reporting to understand the business, cash GST so the ATO is paid out of money you have actually banked.

Income Tax Is a Third Question

Taxable income is not settled by ticking a box either. There is no election. The test, set out by the ATO in Taxation Ruling TR 98/1, is which method gives a substantially correct reflex of your income, and the answer depends on what kind of business you run.

Businesses that trade in goods, carry stock or have substantial capital invested in earning income are generally assessed on an earnings basis, which is accruals. Income is derived when the work is done and a recoverable debt arises, not when the customer pays. A company's business income will normally fall here.

The receipts basis, which is cash, can be the correct one for income that depends largely on personal exertion rather than stock or capital. A sole practitioner providing services, with no trading stock and no employees doing the income-earning work, may properly return income as it is received.

The practical points are these. It is not a preference you get to state, it follows from the facts of the business. It can change as the business changes, so a consultant who starts carrying stock or hiring staff to do the work may move onto earnings without doing anything deliberate. And it is decided separately from your GST method, so being on cash GST tells you nothing about your income tax basis.

Profit Is Not Cash

The first month on accruals often produces the same alarmed question: the report says we made $18,000, so where is it?

It is in receivables. Accrual profit counts work you have done and not been paid for, and it excludes the money you collected this month for work you did last month. A profitable month and an empty bank account are entirely compatible, and businesses do fail in exactly that position.

The answer is not to go back to cash. It is to read two reports instead of one. The profit and loss tells you whether the business is working. The cash flow statement, or at a minimum a receivables ageing report, tells you whether you can pay for it. Our guides to reading a profit and loss statement and reading a balance sheet cover what each one is actually telling you, and why cash flow problems happen covers the gap between the two.

Switching Over

Moving your books from cash to accrual is mostly a matter of establishing correct opening balances and then not counting anything twice.

• Pick the start of a financial year. 1 July keeps the comparatives clean and means one basis per tax year rather than a split one.
• List what you are owed and what you owe. Every unpaid customer invoice at the changeover date and every unpaid supplier bill. These become your opening receivables and payables.
• Watch the overlap. Work invoiced before the changeover but paid after it is the place double counting happens. Under cash you would record it when the money arrives. Under accrual it belongs to the old year. It cannot be income in both.
• Decide what to do about GST separately. Changing your bookkeeping basis does not change your GST method, and changing your GST method has its own transitional rules so that nothing is reported twice or missed. Talk to your accountant before you change either.
• Check the software settings. Most platforms keep one ledger and produce both cash and accrual reports from it, which is why the reporting basis on a saved report matters as much as the setting on the file.

The list is short, but the opening balances are worth getting help with. An error there does not show up as an error, it shows up as a profit figure that is quietly wrong for a year.

Frequently Asked Questions

Does registering for GST force me onto accrual accounting?

No. If your aggregated turnover is under $10 million you can choose the cash basis for GST. The claim that GST registration requires accruals is common and wrong, and acting on it means remitting GST on invoices you have not been paid for.

Can my books be on accrual while my BAS is on cash?

Yes, and it is a sensible combination. The ledger holds every invoice and bill either way. Your software produces the activity statement on whichever basis you have chosen with the ATO.

Is accrual accounting compulsory for a company?

A company's business income will generally be assessed on an earnings basis, and the accounting standards that apply to financial reports are accrual based. In practice a company operates on accruals. Its GST method is still a separate choice.

Which method do lenders want to see?

Accrual. A bank or an investor assessing the business wants profitability matched to the period it was earned, not a bank statement rearranged into a report. If you expect to borrow, being on accruals well before you apply is worth more than converting for the application.

What is unearned revenue?

Money received before the work is done: a deposit, a year of a subscription paid upfront, a retainer for next quarter. Under accrual it is a liability, not income, until you deliver. It is the least intuitive part of the method and the part most often recorded wrongly.

Do I have to change my GST method at the same time?

No. They are independent. Changing one and not the other is fine and often deliberate.

---

Accrual accounting is not complicated once the three questions are kept apart. How you keep your books is a management decision. How you report GST is a choice the turnover test usually leaves open to you. How your income is taxed follows the facts of your business rather than a preference.

Trew North Accounting sets up and reviews exactly this for Melbourne businesses. See our bookkeeping and accounting and tax planning services, or get in touch.

This article is general information, not advice for your circumstances. Thresholds and rules change. Check current requirements with the ATO or with us before you lodge.