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Simple example of accrual accounting. Created by Sal Khan.
Video transcript
Let's now account for the same series of events but instead of doing it on a cash basis let's do it on an accrual basis. And the whole idea with accrual accounting, is to match your revenues and expenses to when you actually perform the service, so it actual captures a business activity, as opposed to just capturing when cash changes hands. So let's see what that actually means. So in month 1 you cater an even where the cost to you was $100 The customer pays you $200 for your services And what I'll do, I'll do the accrual accounting right here So this kind of the cash income statement, let's do the accrual accounting income statement. So you actually provided the service of catering, you got $200 for your services, so I'll put $200 in for revenue. And the expenses associated with that service that you provided in month 1 is $100. And so your profit is $100. So at least for month 1, the cash basis and the accrual basis of accounting look exactly the same. And once again you have $100 in cash. Now let's go to month 2: You cater an event where the cost to you was $200 You and the customer agree that they can pay you $400 the next month. So now it get's interesting, because you performed the catering that month and the catering you performed that month is worth $400. So in the accrual basis of accounting, you would say that you earned $400 of revenue in this month. Even though the customer did not pay you, they did not give you the cash. The way that you account for that, is on your balance sheet, you say that you are essentially owed $400, so this accounts receivable this is essential stuff that other people owe you, you need to receive this from other people, but it's an asset, other people have an obligation to you So you have accounts receivable of $400 When they pay you the $400, it goes from accounts receivable to cash. And then the cost to you was $200. So the cost to you was $200. So here all of a sudden, you performed the service, the revenues and expenses for that service are in that month, and now your profit here shows $200, so it is actually a better reflection of what you did that month. Now, the reality is you didn't get the cash forward, and you had to spend $200 of cash out of your pocket, so you're still, just like the cash accounting, you're still going to have negative $100 in cash. Now let's go to month 3. You get $400 from the customer the previous month. Now, with cash basis, you would have added that to your revenue, but here, we already accounted for it in the accounts receivable, we already took that revenue. But because you've got the $400 in cash, it's going to disappear from receivables, and then go into cash, cause you actually got it. You get $400 from the customer in the previous month. You also get $200 in advance from a customer that you have to cater for next month So you did no catering in month 3, and because you did no catering in month 3, you have 0 revenue in month 3, and then you also have 0 expenses, the way that you account for the $400 that you got, is that your accounts receivables goes to 0, and that goes to cash, so the negative $100 you add $400 to it, so it becomes positive $300. And the way that you account for this $200 in advance from a customer, is you call that deferred revenue. You got the cash there, so we went from negative $100 added $400 to $300 and you had another $200 in cash, so that gives us $500 in cash again, but we didn't earn any revenue, that $200, that was a kind of cash advance, so we put that right over here in deferred revenue, that's revenue that we're deferring to a future period, in the future we will earn, this is now a liability because we were obligated to earn that revenue. And then in month 4 we actually earned the revenue. So in month 4, we can actually put it in our income statement at $200, and then we had $100 of expenses, so that we have this $100 right over here. And so in month 4 we earned $100, and once again, $100 went away from our cash balance, so we still have $400. So whether you do the cash basis or accrual basis you have the same exact amount of cash, what's more interesting is how the profit relates in each of the periods, and I'll talk about that in a little more depth in the next video.