Cash vs Accrual Accounting: What the ATO Actually Requires

Choosing between cash or accrual basis accounting sounds like a simple either/or — but business owners regularly tell us they are “on cash basis” without realising the term means three different things. As a small business accountant in Penrith, we untangle this most weeks, because three separate questions are usually knotted together:

• how income is recognised for income tax;
• how GST is reported on the BAS; and
• how the financial statements are prepared.

Each is governed by different rules, and you can sit on a different basis for each. This article explains the difference, with the legislation and ATO guidance behind every point.

The two methods, in plain terms

At its core the distinction is about timing — when a transaction hits your books.

Under the cash basis (the ATO calls this the receipts method), you record income when money is actually received and expenses when they are actually paid. Under the accrual basis (the earnings method), you record income when it is earned and expenses when they are incurred — regardless of when cash changes hands.

Income tax: you don’t simply “choose”

Assessable income is brought to account when it is derived — see section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). The Act does not prescribe a single method. Instead the leading guidance is Taxation Ruling TR 98/1 — Income tax: determination of income; receipts versus earnings, supported by the ATO’s plain-English guide to accounting methods for business income.

TR 98/1 makes the key point that a taxpayer must adopt the method that, in their circumstances, gives a “substantially correct reflex” of true income. It is a test of appropriateness, not free choice:

• The receipts (cash) method is generally appropriate where income flows principally from the taxpayer’s own personal exertion, knowledge or skill — think salary and wage earners, and many sole-trader service providers who give little or no credit.
• The earnings (accrual) method is generally required for trading and manufacturing income, for companies, and wherever a business has formal systems for extending credit and collecting debts.

This reflects long-standing case law: Carden’s case (1938) 63 CLR 108, Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314, and Henderson v FCT (1970) 119 CLR 612 — the last of which confirmed that a large professional practice giving credit had to move from cash to accruals because cash no longer reflected its real income.

Why you cannot use cash basis for your financial statements

This is the question we are asked most, and the answer is clear: financial statements are prepared on an accrual basis. This is not an ATO rule — it sits in accounting standards and the Corporations Act.

The Conceptual Framework for Financial Reporting and the Australian Accounting Standards (for example AASB 101 Presentation of Financial Statements, and AASB 1060 for Tier 2 simplified disclosures) are built on the accrual basis of accounting. Accrual accounting is the mechanism that lets the accounts portray the effects of transactions in the period they occur, rather than only when cash moves.

For companies, section 296 of the Corporations Act 2001 requires the financial report to comply with the accounting standards, and section 297 requires it to give a true and fair view. A pure cash-basis ledger cannot do this, because by definition it:

• ignores debtors (money owed to you) and creditors (money you owe);
• ignores accruals, prepayments and provisions; and
• cannot produce a meaningful balance sheet.

Buy a computer on credit and a cash ledger shows nothing until you pay — even though you own the asset and owe the debt today. That is precisely the gap accrual accounting exists to close. So while a micro sole trader might keep a simple cash book for convenience, any properly prepared set of financial statements — the kind a lender, the ATO, ASIC or a buyer relies on — must be on an accrual basis.

Why there is no longer an “STS method” to use

You may have read older material suggesting eligible small businesses could elect the Simplified Tax System (STS) and account for income tax on a mandated cash basis. That option no longer exists, and relying on it is a genuine trap.

The STS was introduced by the New Business Tax System (Simplified Tax System) Act 2001, which inserted Division 328 into the ITAA 1997. Originally, electing into the STS forced you onto an STS cash accounting method for most income and deductions.

Two changes dismantled that:

1. From 1 July 2005, the compulsory STS cash accounting requirement was removed. STS participants could thereafter use whichever method — cash or accruals — was most appropriate to their circumstances.
2. The Tax Laws Amendment (Small Business) Act 2007 then replaced the STS entirely with the broader “small business entity” framework in Division 328, effective from the 2007–08 income year. The label “STS taxpayer” was retired.

GST cash basis is NOT cash basis accounting

This is the final piece of the tangle. When you register for GST you can choose to account for GST on a cash basis — but that choice does one thing only: it changes the timing of GST attribution on your BAS. It says nothing about your income tax method and nothing about how your financial statements are prepared.

The rules sit in Division 29 of the A New Tax System (Goods and Services Tax) Act 1999 (the GST Act). The election to use the cash basis is made under section 29-40, and broadly a business with an aggregated turnover under $10 million (or otherwise eligible) can choose it. On a GST cash basis you attribute GST when payment is made or received; on a GST accruals (non-cash) basis you attribute it to the earlier of invoice or payment.

So which basis applies to you?

As a rule of thumb, treat the three questions separately:

1. Financial statements — prepare them on an accrual basis. There is effectively no compliant cash-basis alternative.
2. Income tax — follow the s 6-5 / TR 98/1 appropriateness test: accruals for most trading and credit-giving businesses, cash only for genuine personal-services income.
3. GST — a separate, eligibility-based election on the BAS, available to most businesses under $10 million turnover.

The right combination depends on your structure, turnover and how you invoice — and getting it wrong can misstate your tax in either direction, which is why it is worth confirming the position with a tax accountant in Penrith before lodgement.

Frequently asked questions

This article is general information only and does not constitute personal taxation, accounting or financial advice. It does not take into account your particular objectives, financial situation or needs. Legislation, rulings and thresholds referred to are current as at the date of publication and may change. You should obtain advice specific to your circumstances from a registered tax agent or qualified accountant before acting. i-accountant Pty Ltd is a Chartered Accounting practice and Registered Tax Agent.