To see the difference between
cash accounting and accrual accounting, I'm going to go
through this little example. And first I'm going
to account for things using a cash basis
of accounting. And then we'll do it
with an accrual basis. And just so you
have some context, the cash basis is any time
you get cash from a customer, you would count that as revenue. And any time you
have to spend cash, you count that as an expense. And you'll see that that's
what most small businesses do, while most slightly more
sophisticated businesses would use accrual-based accounting,
because that matches up your actual expenses and your
revenue a little bit better in each period. So let's just go
through this example, using the cash basis first. And we're going to assume that
we start off with no money. So in Month 1, you cater an
event where the cost to you was $100. The customer pays you
$200 for your services. And maybe they pay your
$200 ahead of time, so that you have the cash to go
buy the food and the paper cups and paper plates or whatever. So you get $200 in revenue. This is a cash
basis of accounting. And you get to spend
$100 of that on supplies, and maybe you had
to hire some help, and you had to pay
yourself a salary. So if you got $200, and
you used $100 of that, your profit here-- I'll
do profit in green -- your profit is going to
be-- no, that's not green-- your profit is going to be $100. And if you started
with no cash, your cash at the end of
period-- this is going to be the cash at
the end of Month 1-- you will now have $100 of 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 in this month,
we have to use $200, maybe our bank
lets us overdraft, so let's say-- I shouldn't
write-- This is an expense, so I don't have
to write negative, we're assuming this is going
out, I'll write it in red. So we are going to use $200,
but we don't get any revenue because we're doing the
cash basis accounting. The customer's not
paying us in that month. They're paying us
$400 the next month. So we get no revenue
in that period. So it looks like
we got no revenue. We had $200 of expenses. Our profit here is going
to be negative $200. And when we look
at how much cash, we had $100 of cash
entering into Month 2. We're using $200 of that. And so now we've kind of
overdrawn our bank balance. Maybe we owe our bank now $100. Let's go to Month 2. 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 we've done no
catering this month, but we've got a lot of money. We got $400 from the
previous month's customer and $200 for a
customer that you're going to cater for next month. So we got $600 on the
cash basis in revenue. And we had no expenses
in that month. So we have $600 in profit,
and our cash balance increases by $600. So at the end of this
month, we now have $500. Now Month 4, you cater
the last customer's event. It cost you $100. So once again, you
just have to spend-- I want to do that in
magenta-- you just have to spend the $100 in Month
4 to cater the actual event, but you got no
revenue in that month. So it looks like you took
a loss, negative $100. And then your cash balance
will go down to $400. So this is a cash basis. This is how a lot of
businesses run it. But as you can see,
there's a problem here. It looks like our profit is
jumping all over the place. Sometimes we're profitable,
sometimes we're not. Sometimes we're profitable,
sometimes we're not. Even though our business is a
little bit steadier than that would seem to imply.