Cash and ACCRUAL Accounting - Conceptual
This is Jim. He mows lawns.
In his first week mowing lawns, Jim buys ten dollars worth of gasoline, which will last
him for two weeks. Jim then goes and mows a lawn.
He isn't paid for mowing the lawn yet.
In week two, Jim goes, and mows the lawn again. This week, Jim is paid twenty dollars for
the two weeks of work from the owner of the lawn.
What is the story of Jim's income? What would his income statement for each week
look like?
In week one, Jim received zero dollars in cash, and he spent ten dollars of cash on
his expenses. His total for week one was negative ten dollars.
In week two, Jim received twenty dollars in cash, and he did not spend any cash on his
expenses. His week two total is twenty dollars of income.
In total, he lost ten dollars in week one, and he made twenty dollars in week two.
The story, as told here, tells us literally what happened in Jim's business.
The name for this method of telling the story is called CASH BASIS accounting.
This is because it literally tells us how "cash happens."
If you were an investor, and Jim's story was told using the CASH BASIS as seen here, would
you want to invest in this business?
In reality, if we reflect on Jim's story, we could conclude that over the two-week period,
Jim earned a total of twenty dollars mowing lawns, and paid a total of ten dollars in
expenses; thereby earning ten dollars in total profit.
It would be more representative of the business to say that the business earned five dollars
in each week.
Rather than seeing the story told on a CASH BASIS, an investor might be better served
if Jim's story was told in a more representative way, rather than showing how activities literally
happen from week to week.
In order for investors to make a decision about a business, they usually will want the
story told using what is called ACCRUAL BASIS accounting.
ACCRUAL accounting is a way to tell the company's story so that it more effectively shows how
a company is either making a profit or losing money during a particular period.
ACCRUAL accounting is based on two rules. The first rule is that revenue is shown on
the books when it is earned, without regard to when "cash happens."
The second rule is that expenses are not written on the income statement until they are actually
"incurred," or used. The goal is to match expenses with the revenue that they helped
the business to earn.
If Jim's story was going to be told using these two rules, how would it be told?
First, in week one, how much money was EARNED? We do not care how much cash he received,
we only care how much he EARNED. Even though he has not got paid yet, he has
still EARNED ten dollars in week one. The same goes for week two, he EARNED another
ten dollars. He earned ten dollars in each week.
Next, how much of the ten dollars he spent on gas should be recognized in week one? And
how much should be recognized in week two? Jim used half of the gasoline in each week.
Therefore, five dollars is shown as an expense in week 1, and five dollars is shown as an
expense in week 2. The business earned five dollars in each week.
This is ACCRUAL Accounting.
As seen, by using ACCRUAL accounting, we have more effectively shown the activity of the
business for investors to be able to judge the business.
ACCRUAL accounting allows us to show how much was actually earned, and how much was actually
used in each week, so that we have a more representative story.
As a review: By telling the story based on when CASH literally
happens, a story is told using the CASH BASIS of accounting.
By telling the story based on when Revenues are actually EARNED, and when Expenses are
actually incurred, a story is told using ACCRUAL accounting.
Investors usually want to see the story told using the ACCRUAL BASIS of accounting in order
to make an investment decision concerning the business.
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