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Current time:0:00Total duration:4:01

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 a 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 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 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 the cat either basis on month one it gives you the same thing so that's not so interesting but let's go to month two and 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 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 go look at the accrual basis it better reflects it 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 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 can actually so look I perform 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 benefits so both cash and accounts receivables are assets and so in months do I think it's fair that accrual method is giving us a better indication of what actually happened let's go to month 3 on the cash basis and we look at the example we actually did nothing in month 3 you could have gone on a vacation in month 3 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 got $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 see a month 3 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 have 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 to month 4 when you actually perform the service the hundred dollars expenses are associated with that $200 and so it makes sense that you had a hundred dollars in profit once again in month four you did work you should have profit on the 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 a business in the next video I'll try to reconcile the the what the accrual income statement is telling us and the actual cash because right now it might look a little mysterious