Comparing accrual and cash accounting

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.