Mark Farber: Hi.
I'm Mark Farber and this is accounting fundamentals.
What we're going to do in this video is take a look at the difference between two different
systems of accounting.
One is referred to as cash accounting and the other is referred to as accrual accounting.
Accounting, the whole purpose for doing this is to tell a story, to explain to people what's
going on in a company, both internal users and external users.
We want to make sure that we're properly portraying the story of what the activities, what the
business activities are of the company within the period that we're talking about.
And to better explain the difference between cash and accrual accounting, I'm going to
go through a very simple example of a guy who I like to think of as Joe the painter.
On May 1st, I hired Joe to paint my house.
May 1st, he gets hired for the job, and he quotes me a cost 8,000 dollars to do the job.
Then on May 15th, he goes out and he buys all the supplies that he's going to need:
paint, brushes, whatever else, and he pays 3,000 dollars for those supplies, and he purchases
them on account, meaning he hasn't paid cash, he's going to receive an invoice and he's
going to pay that invoice at some point in the future.
On June 3rd, he starts painting the house, and on June 8th, he finishes the job, and
he hands me an invoice for 8,000 dollars, agreed-to price.
Again, he hasn't received cash yet, but he has an account receivable now, as we think
of it, of 8,000 dollars.
Then on June 15th, a month after he purchased the supplies, he's paid for them, so he pays
the 3,000 dollars.
July 8th, he received 8,000 dollars of cash from me in payment for the painting job he's
just done.
We're interested in what happened on a month-to-month basis in this case, so we're going to look
at monthly financial statements.
Well, let's look at cash accounting first.
The premise of cash accounting is we only record cash transactions.
If cash didn't change hands, nothing happened.
Let's go through these transactions and see what we have to record and more importantly,
when we have to record it.
May 1st, hired for the job.
Well, no cash has changed hands yet, so nothing to record.
May 15th, he purchases supplies for the job.
He- sorry.
He purchased 3,000 dollars of supplies, but he hasn't paid for them yet, so again, no
cash has changed hands.
In May, nothing's happened from the point of view of revenue or expenses.
He hasn't paid out any cash and he hasn't received any cash.
Therefore, no profit in May.
June 3rd, he starts painting.
Again, no cash changed hands.
June 8th, finishes the job, gives me an invoice, hasn't received any cash.
On June 15th, he pays 3,000 dollars for the supplies.
Now cash has changed hands.
There was a 3,000 dollar payment in June for supplies, and that was it.
There's no revenue, and therefore revenue minus expenses is profit.
Zero minus 3,000 in the month of June, according to cash accounting, Joe the painter has a
loss of 3,000 dollars.
Then comes July.
His wife, by the way, is a little concerned.
One month no profits, the next month he's got a loss, now she's concerned.
Plus she hasn't seen him doing very much in July.
But on July 8th, he receives 8,000 dollars of cash.
Because he received cash under cash accounting, that gets recorded as revenue.
Even though he hasn't been doing anything in July, he's just been sitting around taking
the summer off, he received revenue.
He had no expenses, he didn't pay out any cash, and consequently, in July, he has 8,000
dollars of profit.
Now his wife is looking at him and say, "You should take vacation more often, Joe, because
somehow you're making money.
When you're running around doing stuff, you're losing money."
This clearly doesn't really tell us though what Joe was doing.
We know that Joe painted the house in the month of June, and yet it doesn't show any
revenue in the month of June.
It doesn't show that he did anything then.
In fact, it shows that he lost money in the month that he was painting, and he had a profit
when he wasn't.
Cash accounting, while very useful for keeping track of cash balances, doesn't really explain
what's been happening within the company.
And so instead, we have something called accrual accounting, and let's put that down here.
We'll just put in accrual accounting.
In accrual accounting, what we try to do is to capture the events in the month, or in
the time period in which they occurred, regardless of when the cash actually changed hands.
Again, I'm going to put in revenue, expenses, and profit, and I'll just put it in very quickly,
May, June, July, stuff 'em in there.
Okay.
Let's go through this again, and this time we'll take a look at it from the point of
view of accrual accounting.
May 1st, he's hired for the job.
Well, he hasn't really done anything.
As we said in a previous video, no assets, liabilities, equity, changed hands.
We simply entered into a contract on May 1st, so there's nothing to record.
On May 15th, he purchased supplies.
He's acquired some supplies, and he owes money, but that's not a revenue or an expense yet,
and we'll explain that in a minute why it's not an expense yet.
Let's just put over here that as of May 15th, he owes 3,000 dollars.
Okay, because he purchased supplies on account, and he has supplies.
Normally, you'd be a little more clinical in how we record that, but we're just going
to put those to the side for the moment.
On June 3rd, he starts painting.
Again, there's no transaction, no accounts have changed.
But on June 8th, he finishes the job.
Now, the question now is does he have revenue?
Well, revenue is defined, essentially as this.
If you have substantially completed the project that you're working on, in this case, or you
have substantially transferred all the rights of ownership of something, if you are selling
a product, and payment is reasonably assured, so you don't necessarily have to have the
cash, you just have to expect that you're going to get the cash.
Then you have revenue.
In this case, he finished the job so he's substantially completed what he had to do.
In fact, he's done everything that he has to do, and he expects that I'm going to pay
him the money, so he can record the revenue when he did the work.
Down here in May, we had nothing.
We'll just put that in.
In June, according to accrual accounting, even though he doesn't have the cash yet,
he has 8,000 dollars of revenue.
Now remember these supplies that he purchased, the 3,000 dollars of supplies.
Well, those supplies were used to earn that revenue.
There's another principle in accounting called the matching principle.
We try to match our expenses to the period in which the revenue was earned.
Because we've earned the revenue, or because Joe earned the revenue in June from painting
the house, at the same time, he used those supplies, so we're going to expense the supplies
in June.
Not because he paid for them in June or any cash changed hands, but that's when they were
used in order to earn revenue.
We’re going to put in the expense of 3,000 dollars for the supplies, and we can scratch
that out now because we've now taken- We no longer own, or Joe no longer owns those supplies,
they've been used up.
In the month of June, we can see that Joe earned 5,000 dollars from painting the house.
Now he still owes 3,000, remember.
Well, on June 15th, he pays for the supplies.
He doesn't owe the money anymore.
His cash has gone down and that's been taken care of.
Then on July 8th, he receives the cash that I owed him.
Remember over here, we booked revenue of 8,000 dollars in June, but he didn't receive the
cash.
He receives the cash in July, but that's not revenue, that's just the payment of cash.
In July, he didn't actually paint any houses, he didn't earn any revenue.
Similarly, he incurred no expenses, and so he has no profit.
Now look at these two.
Under cash accounting, if we netted out profit over the three months, 8,000 minus 3,000,
we see that he had 5,000 dollars of profit.
It's kind of split up, it doesn't really tell us that this 8,000 goes with this 3,000.
It makes it look like he lost money, and then he had a huge profit, whereas under accrual
accounting, this doesn't tell us when he received and paid cash.
We have other statements that tell us that.
It tells us that in the month of June, Joe painted a house, or did work, and earned 8,000
dollars.
He incurred 3,000 dollars of expenses in order to earn the 8,000 dollars, and was left with
a profit of 5,000 dollars.
He didn't earn any money in June or May or July, nor did he incur any expenses in those
months.
It gives us a much better view of what's going on in Joe's painting business, and from this
point forward, we will always use accrual accounting in order to keep track of the events
within a business, and the basic premise is revenue recognition policies.
Was the work substantially completed or was the good substantially delivered, and is payment
reasonably assured?
Obviously, if you've received payment, it's assured.
Then to the extent that we can, matching our expenses, either to the revenue that they
were used to generate, or to the period in which the company got the benefit, something
we'll look at later on, okay.
One other thing that we have to keep in mind with accrual accounting is that we have all
these little things over here: supplies, amounts we owe or amounts that the company owes, et
cetera, or is owed to the company.
Those are called the accruals, and we'll see how those fit in later on in the coming videos.