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Cash vs Accrual Accounting Explained With A Story - YouTube
Channel: Leila Gharani
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Today we're going to cover another topic
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that's often a reason for confusion:
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Cash and Accrual accounting.
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Two very different accounting methods.
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In this video we're going
to take a look at both
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and see how each one
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could affect a business in different ways.
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We'll also see why income and cash
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can be two very different things.
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Lots to cover, let's get started.
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(uplifting music)
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The difference between these two concepts
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is in the timing of when
revenue and expenses
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are recorded in your accounts.
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So just to be clear,
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over time both systems will
get to the same results,
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but at a certain point in
time there may be differences.
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And that's something that's
important to understand,
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especially when it comes
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to analysis of financial statements.
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Let's start with the easier
part, cash accounting.
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Cash-based accounting is
a very intuitive system.
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It recognizes transactions
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only when cash is actually exchanged.
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So revenue is reported
on the income statement
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only when cash is received,
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and expenses are only recorded
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when cash leaves your account.
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So under this method it doesn't matter
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in which month you did
the work for your client
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or you sent an invoice to your customer.
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The only thing that matters is
when they actually paid you.
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Same thing for expenses.
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Even when you purchase all kinds of stuff
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on credit for your business,
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it won't show in your income
statement until you pay for it.
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So this can be your
accounting method of choice
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because, well one, it's intuitive
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and it's simple to understand.
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Two is that, as a business owner,
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cash is the most important
topic to be on top of,
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and cash accounting helps you do that.
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Number three, you might even be able
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to do your own bookkeeping in Excel.
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Meaning, it's much cheaper
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than having to pay for
specialized accounting software
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or for someone to do
the bookkeeping for you.
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Number four, it's an accepted
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accounting method in most
countries, also for tax purposes.
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The rules vary by country, but generally,
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cash accounting can be applied
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if the business stays below
a certain revenue threshold
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or it doesn't maintain a lot of inventory.
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So it's a great option for small simple
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and mainly cash-based businesses.
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An accrual accounting
system on the other hand
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is based on when the transaction happens
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rather than when cash changes hands.
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In other words, revenue is
reported when it's earned
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and expenses are recorded
when they are incurred.
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So for example, if your
company sells goods in January
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but isn't paid until February,
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then the revenue isn't
recorded until February
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under the cash accounting method.
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But it would be reported in January
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under the accrual accounting method.
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Let's better understand the difference
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between cash and accrual accounting,
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especially because it seems
cash accounting is much easier.
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Why do we even need accrual accounting?
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Let's try to answer that.
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Remember Claudio and his
Italian beach business?
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Like any other day, Claudio today
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goes to his trusted manufacturer
of tourist souvenirs
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to buy his supply of plates.
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This time though, the
manufacturer tells Claudio
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that he wants to optimize his processes
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and he was to avoid the
daily cash transactions.
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He would like to bring
out the cash register
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only just once per week,
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and because Claudio has been
a great customer for him,
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he'd be willing to give him credit.
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So they agree to settle
the purchases for the week
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always on Fridays.
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For Claudio this is a great deal,
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because he doesn't have to pay right away.
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He's working with somebody else's money.
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This way we can even expand
his souvenir business
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and buy another item to sell
from another manufacturer
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with his initial 100 euros.
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In business we call this
the leverage effect.
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So Claudio decides to
go ahead with this idea
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and invests is 100 euros in another item,
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and buys 50 hats in cash.
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He pays two euros for each hat
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and plans to sell them for
10 euros to the tourists.
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Now, at the beach he has a 100
plates and 50 hats to sell.
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His friend, let's call him Mario,
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comes along and sees the
new hats Claudio is selling
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and he really likes them.
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He tells Claudio that
he wants to buy 30 hats
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for this event he's
going to in the evening,
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but he can only pay for them tomorrow
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after he sold them at the event.
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Claudio agrees and hands
over the 30 hats to Mario.
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He stays at the beach and
sells the rest of his souvenirs
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and then goes home.
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He counts the money in
his pocket as usual,
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and it turns out to be 700 euros.
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He deducts initial investment of 100 euros
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that he left the house with,
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and this gets him to
a profit of 600 euros.
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Is this correct?
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The answer is, it depends.
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It depends if Claudio's applying
the cash accounting method
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or accrual accounting.
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As we've learned, the
difference between the two
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lies in the timing of
when sales and purchases
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are recorded in your accounts.
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So let's apply cash accounting
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to create Claudio's income statement.
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His revenue consists of the 20 hats
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and 100 plates he sold at the beach.
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The 30 hats for Mario
are not accounted for
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because he didn't get paid for it yet.
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Likewise for his expenses,
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only the 100 euros for
the hats are recorded,
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because the plates he didn't pay for.
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Basically, this gives us exactly
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the profit Claudio is calculating
by using his usual method
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of counting the cash in his pocket.
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And really, this is what it is.
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Only transactions that have
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an impact on cash are considered.
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And we can already see
the problem with that.
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It doesn't provide a complete picture
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of what happened during the day.
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In reality, he sold all of his inventory,
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but in the income statement
we don't see the full revenue.
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Another problem is that we show
revenue for the 100 plates,
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but no corresponding
cost of the goods sold.
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In other words, the costs
don't follow the revenue,
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which can present quite
a misleading picture
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of the company's profitability.
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Now let's take a look
at accrual accounting.
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With this method revenue
is considered when earned,
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but what does that mean exactly?
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This can be quite a complicated topic.
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But in a nutshell, revenue is earned
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when the products were
delivered to the customer
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or services were provided,
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and it's reasonable to expect
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that cash will be received
from the customer.
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The recognition of expenses
follows the matching principle,
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which means that they are
recognized in the period
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in which the related
revenue is recognized.
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Let's see how that looks like for Claudio.
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His revenue will include
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all products he sold during the day,
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meaning, also the revenue for
the 30 hats he sold to Mario
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and didn't receive cash for.
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Why? Because he handed over the hats,
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he fulfilled his part of the deal,
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and Claudio doesn't have any reason
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to expect Mario is not going to pay him.
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Therefore, Claudio's
revenue is 300 euros higher
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than under the cash accounting.
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What about his costs?
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By applying the matching principle,
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the expenses should be
recognized in the same period
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as the revenues they helped to generate.
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Therefore, we need to report
the cost of goods sold
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for the entire revenue,
which results in COGS of 200.
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This way, the income statement
reports revenue of 1,000
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and a net profit of 800 for the day.
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Quite different than what we would report
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under cash accounting.
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In addition, in the balance sheet,
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we would have to report
accounts receivable,
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the 300 Euros Mario still owes Claudio,
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and accounts payable. The 100 Euros
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Claudio owes the
manufacturer of the plates.
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Both methods have their
advantages and disadvantages.
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The cash accounting method
provides an accurate picture
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of how much cash a business has.
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It's simple to apply, and
since the transactions
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aren't recorded until the
cash is received or paid,
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the income of the business is not taxed
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until it's in the bank.
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On the other hand, it doesn't
provide a full picture,
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and because it doesn't report
receivables or payables,
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it doesn't show outstanding invoices
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that haven't been paid yet.
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The accrual method on the other hand
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gives a more accurate
picture of the business.
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If the company has to
report under GAAP or IFRS,
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then that's the accepted method.
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But it means more complex
processes in accounting.
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And its purpose is not to track cash flow.
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So the key point here is
that reported income and cash
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can be two very different things.
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Therefore, under accrual accounting,
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don't just look at the income statement
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or the balance sheet.
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Focus on the cashflow statement as well
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to see if the business
is able to generate cash,
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which is the lifeblood of any business.
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I hope this video was helpful for you
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to get familiar with these
two accounting methods.
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If you enjoyed this video,
give it a thumbs up.
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And if you want to improve your
skills, consider subscribing.
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And don't forget to hit that bell
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so you don't miss any
videos we put out here.
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Thank you for watching.
See you in the next video.
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(upbeat music)
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