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Accrual Accounting: How it Works & Why it's #1! - YouTube
Channel: Accounting Stuff
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if that's you you'll need to use the
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accrual basis of accounting instead this
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week via calls basis hey guys welcome
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back to accounting stuff the place where
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we discuss all things accounting up
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until now we've been talking about some
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basic accounting theory last week we
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talked about the cash basis of
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accounting and this week we're going to
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talk about another super important
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method of accounting the accrual basis
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of accounting the accrual basis of
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accounting is considered to be a much
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better method to follow than the cash
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basis because there's so much
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information you can extract from it I'm
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going to explain why most businesses
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when they're starting out tend to cash
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account because it's easy but have you
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ever wanted to have a big companies like
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Apple Amazon and Google do their books
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or pretty much any household name they
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all have one thing in common they use
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the accrual basis of accounting if
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you've never heard of it before don't
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worry I'm gonna explain it all to you
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right now don't forget to stick around
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to the end because I'm gonna talk
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through some of the main advantages of
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using this method and also the reasons
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why most businesses starting out tend
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not to use it let's get cracking in the
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last video I explained the pros and cons
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of the cash basis of accounting if you
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missed it there should be a link
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somewhere up here with the cash basis
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you record your revenue once you receive
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the cash and you record your expenses
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when you pay that cash back out it's a
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great way to do your books and it's
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simple and that's the reason why it's an
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approach used by many small businesses
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and individuals for personal finance
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however there is one big problem with
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this accounting method it can be really
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hard to work out your business's
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profitability particularly when you want
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to work out how much profit you made for
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one particular point in time like one
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month of the year for instance and
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that's because of the time your
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differences between when you recognize
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your revenue and expenses I'll give you
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an example of this in a moment the
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accrual basis of accounting solves this
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issue revenue is recognized as it's
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earned and expenses are recorded as they
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are incurred it's a way of recording the
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substance of transactions and that makes
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it a much much easier way to record the
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performance of your business over a
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specific period of time let me explain
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let's go back to that example of a
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baking business selling a cake that we
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discussed in the previous video the
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ingredients of that cake cost us 10
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dollars to buy and we sold it for 25
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dollars that leaves us with a profit of
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$15 now let's imagine a scenario where
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we sell a cake to a customer on the 25th
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of October the customer has 7 day
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payment terms so we don't receive the
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cash until the 1st of November
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under the cash basis of accounting the
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revenue would be recognized on the 1st
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of November because that's when we
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receive the cash however under the
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accruals basis of accounting the revenue
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would be recognized on the 25th of
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October because that's when the
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substance of the transaction occurred
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that's when we physically handed over
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the cake to the customer now let's also
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imagine that we baked that cake using
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ingredients that we purchased a month
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ago in September under the cash basis of
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accounting we would have recorded the
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expense in September because that's when
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we paid the cash for the ingredients
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however using the accrual basis of
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accounting we would instead record that
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expense in October because that's when
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we sold the cake you can see that under
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the cash basis of accounting we recorded
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a loss of $10 in September and a profit
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of $25 in November this time in
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difference that you can see here could
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cause us a real headache if we wanted to
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look back in time and review our
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performance in October because we
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wouldn't see any profit there it might
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not seem that complicated for this one
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example but imagine that we'd sold a
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hundred cakes and they all had timing
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differences just like this one it would
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be a nightmare to work out our
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profitability for a particular period in
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time because we didn't record the
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substance of the transactions as they
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were incurred however the accrual basis
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of accounting neatly solves this issue
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for us we record both the revenue and
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expense in October so we can see the
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profit of $15 in October just like you'd
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expect our revenues and expenses are
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aligned with each other in the same
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accounting period because in the accrual
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basis of accounting we apply the
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matching principle
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the matching principle simply states
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that revenue and all expenses incurred
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in order to generate that revenue need
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to be recognized in the same accounting
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period this is a key differentiator
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between the cash and accrual methods of
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accounting the matching principle makes
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it easier for us to objectively analyze
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results because you can accurately
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measure your profit over time now that
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we've clarified the accrual basis of
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accounting let's run through some of its
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pros and cons first of all like I just
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said it applies the matching principle
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so business's profitability can be
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accurately measured for specific time
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periods it also measures accounts
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receivable and payable so you can build
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a picture of your financial position and
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it's accepted under GAAP and IFRS so
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it's possible to produce financial
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statements under these principles and
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standards on the other app on the other
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hand however the accrual basis of
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accounting doesn't explicitly track cash
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flow so this needs to be calculated
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separately using the direct or indirect
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method it's also more complicated than
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the cash method of accounting because
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you have to make estimates and
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assumptions
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this can be unsuitable for small
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businesses hence why many of them choose
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to adopt the cash method of accounting
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instead if you deciding which of these
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methods to use for your business and you
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will need to weigh up the pros and cons
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of each in order to come to a decision
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both of these methods are usually
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allowed for tax purposes although the
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cash basis is normally only an option if
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your revenues are below a certain
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threshold you can google what that
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threshold is on your tax authorities
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website it's also important to know that
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whichever method you choose could impact
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your tax payments by bringing them
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forwards or backwards depending on your
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situation however in the long run both
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the cash and accruals methods tend to
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produce the same result most startups
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and small businesses tend to start off
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with the cash method of accounting
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because it's easier to apply and it's a
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good way to track cash flow however if
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and when those businesses continue to
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grow there may come a point where it
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makes sense to make the switch to the
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毛cause basis of accounting instead
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that's all for today thank you for
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watching if you found this video useful
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give it a like subscribe if you haven't
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already and hit that little bell to be
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notified when the next video
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I'm thinking of doing some longer form
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videos where we were through some
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practice questions and model answers to
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reinforce these ideas if you think you'd
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find that useful let me know in the
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comments below I've had a great time
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learning with you today to a next time
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