Cash versus accrual accounting
Comparing Accrual and Cash Accounting Comparing Accrual and Cash Accounting
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- 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 a buisness and that might be for investors, to see how a buisness is doing, or it might be for the managers of a buisness
- So they can see where the buisness is doing well, where it's not doing well, or maybe how rescorces should be allocated
- So let's se which of these two methods of accouting, the cash method and the accrual method
- Give a better indication of what's actually going on in the buisness, and the way I did it in the first two videos, the first column over here
- This is the cash basis of accounting and this is the accrual, and let's just look at the income statement
- We are assuming a very simple world, were the is no taxes, we have no debt, we have no intrest or things
- like that. We just litterally have Revenue and just a simple profit.
- And 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 and a Accurual basis
- Now when you look at either basis on month one, it's the same thing so it's not that interesting
- But let's go to month two. On the cash basis of accounting it looks like you just lost $200
- To a outsider who doesn't know the details of what's actually going on it would seem somthing shady
- is going on or it's a money losing buisness.
- "Why would I want to invest in this buisness that's losing $200 a month?"
- But if you look at the accrual basis it better reflects that you actually did some catering
- that month. As a matter of fact, you did a pretty large catering.
- So if you recognise the Revenue for the service you actually did that month, that $400
- You could say look, I performed services that will earn me $200 in the future
- Assuming the customer is good for the 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, which is still a asset
- A asset is anything someone owes you some future benefit.
- So the customer is going to give you cash in the future.
- Cash is a asset because you can use it to buy stuff and get people to do stuff for you
- To get some future benefit.
- So both cash and Accounts Receivables are assets.
- So in month two I think it's fair that the Accrual method is giving us a better indication
- of what's actually going on.
- Let's go to month three. When you look at the example, you actually did nothing on month three.
- You could have gone on vacation on month three.
- There was no catering done.
- But on a cash basis it looks like it was your best catering month ever
- Because you got $600 inflow in cash.
- And you didn't have to spend any expenses because you didn't do any accounting.
- But when you look at the Accrual basis it actually reflected what happened.
- You had no Revenue and no expenses assosiated with the Revenue.
- So once again, to a outsider they'd say maybe you took a break, maybe a vactation,
- Or maybe it was just slow time in your buisness.
- And you don't recognize these $200 in advance
- Because you didn't do anything to get it.
- You said: Look. I got this $200. It's a cash advance.
- You could even say it's a cash advance from customers.
- But I'm not recognizing the Revenue in the month that I got it.
- I'm waiting until I actually do the service. So I'm deferring the Revenue.
- So you defer it to month four, when you actually perform the service.
- On the cash basis it looks like you lost money again.
- So hopefully this gives you a idea of why accrual gives a better picture
- of what's happening in a buisness.
- In the next video, I'll try to reconcile what the Accrual income statement is telling us
- and the actual cash.
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