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Course: Finance and capital markets > Unit 5
Lesson 1: Cash versus accrual accountingComparing accrual and cash accounting
Comparing Accrual and Cash Accounting. Created by Sal Khan.
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what is the difference between the concepts of "accrual" and "deferred"? I got confused about the two. Another question is which of those means "prepaid",and which of those means "delayed"?(1 vote)
Accrual is a type of accounting wherein the entries are recorded when the transaction actually takes place usually on the invoice date and the money is not paid yet.
Deferred is referred to the payment that is paid in advance and no service is rendered against the payment. After you provide the service, the deferred payment will be transferred to cash.(9 votes)
If I went to a flower shop to purchase a dozen roses. I didn't use cash, but used a credit card for the purchase.
Would this example of Accrual Accounting or of Cash-basis accounting?(2 votes)
Why would anyone use cash accounting?(2 votes)
I would think it's an intuitive way for small business owners, who run a simple operation, to keep track of their expenses.(4 votes)
- why does cash go down in the last month by $100 (from $500 to $400) when the profit was $100?(2 votes)
Because the event cost you $100, and the revenue for that event was received the month before (in the accrual system).(3 votes)
- Should the "Cash" amount in month 3 (accrual basis) not be $300 since the $200 was being deferred to month 4? I'm trying to follow and the $100 profit in month 4 added to the cash of month 3 then should equal $600??(2 votes)
- No, the Cash amount is correct because if you take a look at the original problem, you were paid the $200 in advance. The deferral is in reference to when you actually earn the income(perform the service) vs simply being paid. Yes you were paid in advance, but you have not yet performed the services for which you were paid :)
You had -$100 in cash from month 2, but were owed $400 (Recognized under accounts receivable). That along with the advanced $200 payment = $500 Cash at the end of the 3rd month!
The $100 profit in month 4 is written in recognition for actually catering the event that you had been paid in advance for. It is recorded in the accrual basis to help see and recognize what was going on in the month! You don't actually add that to your cash balance since it was already accounted for (received) in the previous month. (Unfortunately your profit and cash balance aren't always the same like the first month)
Your cash balance was at $500 from month 3, but the catering event in month 4 racks up $100 in expenses, leaving with you $400 at the end of month 4.
- To recap, remember that you were paid $200 in month 3 to cater an event the following month, that amount was recognized as cash as well as deferred income since you had not catered yet. In month 4, you take that $200 of deferred income and properly record it as your revenue for the month, alongside $100 of expenses. That leaves $100 of profit for the month, but since you did not receive any other income in the form of cash during that month, $100 of expenses is still subtracted from the cash balance.
Hopefully that helps!(3 votes)
How do credit card charges show up in cash vs accrual accounting? Should charges be dated when they were charged OR when the credit card was paid? It sure would be great to see how credit card charges affect the above. Also, similarly, when checks are written OR when they are cashed by the recipient? Often times, when things are charged and when they are actually paid/cashed fall into separate months. Let's keep this to a simple small business scenario if possible.(4 votes)- This is a great question! Credit cards are stored as credit, meaning yes it is stored under accounts receivable. I also would like someone to answer when it gets moved to the cash account. I assume that it is when the credit card company like American Express sends the payment to the organization it will be moved to cash, but I have not been taught what truly happens.(1 vote)
Is Deferred Revenue the same as Accounts Payable? If not, what is the difference between them?(2 votes)- Does double-entry accounting have anything to do with either of these two methods?(1 vote)
Would it be correct to say that what accrual accounting is to cash accounting, is what fair value accounting is to historical cost accounting?(1 vote)- That's a weird analogy. It's like saying breakfast is to lunch what lunch is to dinner: yeah, the first one in each pair comes first, but there are lots of other aspects to them as well.(2 votes)
- How can I add shares in the account and creat the account under in which account group?(1 vote)
Video transcript
So one of the main purposes
of accounting for anything, of making these accounting
statements in the first place, is so that you
can reflect what's going on in the business. And that might be for investors,
to see how business is doing, or it might be for the
managers of a business, so that they can see where
the business is doing well, or where it's not
doing well, or maybe how resources
should be allocated. So let's see which of these two
methods of accounting, the cash method or the accrual method,
give a better indication of what's actually going
on in the business. And the way I did it in
the first two videos, for each month, this first
column right over here, this is the cash
basis of accounting. And this right here
is the accrual. So the second column
is the accrual. Let's just look at
the income statement. We're assuming a very simple
world where there's no taxes. We have no debt. We have no interest,
things like that. We just literally have revenue,
some expenses associated with that revenue, and
just a simple profit. We'll make it more
complicated in the future. So this right here, you could
view as our income statement. This is our income statement
for month one on a cash basis. This is our income statement on
month one on an accrual basis. Now when you look at the
cash basis in month one, and when you look at
either basis on month one, it gives you the same thing. So that's not so interesting. Let's go to month two. In the cash basis
of accounting, it looks like you just lost $200. To an outsider who didn't know
the details of what's actually going on in the
business, they think something shady is going on, or
it's a money losing business. Why would I want
to invest in this? They're losing $200 a month,
just looking at this month alone. But when you look at
the accrual basis, it better reflects that look,
you actually did some catering. In fact, you did a pretty large
catering event that month. In fact, that's why you
had so many expenses. And if you recognize the
revenue for the service that you actually
did that month, that $400, which we did
in the accrual basis, then you could
actually say, look, I performed services
that will earn me $200, assuming that the
customer is going to be good for their money. And instead of putting that
$400 in cash, because you didn't get the cash, you can't do that. We said, look, the
customer owes us $400. But that's still an asset. An asset is anything
that someone owes you, some future benefit. So the customer is going to
give you cash in the future. Cash is an asset because you
can use that to go buy stuff, to get other people
to do stuff for you, to get some future benefit. So both cash and accounts
receivables are assets. And so in month two,
I think it's fair that accrual method is giving
us a better indication of what actually happened. Let's go to month three. On the cash basis, when
you look at the example, you actually did
nothing in month three. You could have gone on a
vacation in month three. There was no actual
catering done. But on the cash basis,
it looks like this was your best month of catering
ever, because you actually get $600 inflow in
cash, and you didn't have to spend any
expenses, because you didn't do any accounting. But when you do
the accrual basis, it actually reflected
what happened. You had no revenue
and no expenses associated with that revenue. So once again, to an
outsider, they'd say, hey month three, maybe
you took a break, maybe you took a
vacation, or that was just a slow time in your business. And you don't
recognize the revenue from this $200 in advance,
because you didn't do anything to get it. Instead, you said, look, I got
this $200, it's a cash advance, you could've even called this
a cash advance from customers, but I'm not recognizing
this in revenue in the month that I got it. I'm waiting until I actually
perform the service. So I'm deferring the revenue. And so you defer it to
month four when you actually perform the service. The $100 in expenses are
associated with that $200. And so it makes sense to
you had $100 in profit. Once again, in month
four, you did work, you should have profit. On a cash basis, it looks
like you lost money again. So hopefully this
gives you a little bit of an idea of why accrual gives
a better picture of what's happening in the business. In the next video, I'll try
to reconcile what the accrual income statement is telling
us and the actual cash, because right now it might
look a little mysterious.