Comparing accrual and cash accounting | Finance & Capital Markets | Khan Academy

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..

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