Simple example of cash accounting. Created by Sal Khan.
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.