If that's you you'll need to use the Accrual Basis of Accounting
instead. This week…
The Accrual Basis.
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Hey guys Welcome back to Accounting Stuff.
The place where we discuss all things Accounting. Up until now we've been talking about some
basic Accounting Theory. Last week we talked about the Cash Basis of
Accounting and this week we're going to talk about another
super important method of Accounting.
The Accrual Basis of Accounting. The Accrual Basis of Accounting is considered
to be a much better method to follow than the Cash Basis
because there's so much information that you can extract from it.
I'm going to explain why. Most businesses when they're starting out
tend to Cash Account because it's easier. But have you ever wondered how the big companies
like Apple, Amazon and Google do their books? Or pretty much any household name?
They all have one thing in common… They use the Accrual Basis of Accounting.
If you've never heard of it before don't worry… I'm going to explain it all to you
right now. Don't forget to stick around till the end
because I'm gonna talk through some of the main advantages of using this method
and also the reasons why most businesses starting out tend not to use it.
Let's get cracking! In the last video, I explained the Pros and
Cons of the Cash Basis of Accounting. If you missed it there should be a link somewhere
up here… With the Cash Basis
you record your revenue once you receive the cash
and you record your expenses when you pay that cash back out.
It's a great way to do your books and it's simple
and that's the reason why it's an approach used by many small businesses and individuals
for personal finance. However there is one big problem with this
accounting method… it can be really hard to work out your business'
profitability. Particularly when you want to work out how
much profit you made for one particular point in time
like one month of the year for instance. And that's because of the timing differences
between when you recognise your revenue and expenses.
I’ll give you an example of this in a moment. The Accrual Basis of Accounting solves this
issue. Revenue is recognised as it's earned
and expenses are recorded as they are incurred. It's a way of recording the substance of transactions
and that makes it a much much easier way to record the performance of your business over
a specific period of time. Let me explain…
Let's go back to that example of a baking business selling a cake that we discussed
in the previous video. The ingredients of that cake cost us 10 dollars
to buy and we sold it for 25 dollars.
That leaves us with a profit of $15. Now let's imagine a scenario where we sell
a cake to a customer on the 25th of October. The customer has 7 day payment terms
so we don't receive the cash until the 1st of November.
Under the Cash Basis of Accounting the revenue would be recognised on the 1st
of November because that's when we received the cash.
However under the Accrual Basis of Accounting the revenue would be recognised on the 25th
of October because that's when the substance of the transaction
occurred that's when we physically handed over the
cake to the customer. Now let's also imagine
that we baked that cake using ingredients that we purchased a month ago
in September. Under the Cash Basis of Accounting
we would have recorded the expense in September because that's when we paid the cash for the
ingredients. However using the Accrual Basis of Accounting
we would instead record that expense in October because that's when we sold the cake.
You can see that under the Cash Basis of Accounting we recorded a loss of $10 in September
and a profit of $25 in November. This timing difference that you can see here
could cause us a real headache if we wanted to look back in time and review our performance
in October because we wouldn't see any profit there.
It might not seem that complicated for this one example
but imagine that we'd sold a hundred cakes and they all had timing differences just like
this one. It would be a nightmare to work out our profitability
for a particular period in time because we didn't record the substance of
the transactions as they occurred. However the Accrual Basis of Accounting neatly
solves this issue for us. We record both the revenue and expense in
October so we can see the profit of $15 in October
just like you'd expect. Our revenues and expenses are aligned with
each other in the same accounting period because in the Accrual Basis of Accounting
we apply the Matching Principle. The Matching Principle simply states that
revenue and all expenses incurred in order to generate that revenue
need to be recognised in the same accounting period.
This is a key differentiator between the cash and accrual methods of accounting.
The Matching Principle makes it easier for us to objectively analyse results
because you can accurately measure your profit over time.
Now that we've clarified the Accrual Basis of Accounting
let's run through some of its Pros and Cons. First of all
like I just said it applies the Matching Principle
so a business's profitability can be accurately measured for specific time periods.
It also measures Accounts Receivable and Payable so you can build a picture of your financial
position. And it's accepted under GAAP and IFRS
so it's possible to produce financial statements under these principles and standards.
On the other ‘an
*prrth
On the other hand however the Accrual Basis of Accounting
doesn't explicitly track cash flow. So this needs to be calculated separately
using the direct or indirect method. It's also more complicated than the Cash Method
of Accounting because you have to make estimates and assumptions.
This can be unsuitable for small businesses hence why many of them choose to adopt
the Cash Method of Accounting instead. If you’re deciding which of these methods
to use for your business then you will need to weigh up the Pros and
Cons of each in order to come to a decision.
Both of these methods are usually allowed for tax purposes
although the Cash Basis is normally only an option
if your revenues are below a certain threshold. You can google what that threshold is on your
tax authorities website. It's also important to note that
whichever method you choose could impact your tax payments
by bringing them forwards or backwards depending on your situation.
However in the long run both the Cash and Accrual methods tend to
produce the same result. Most startups and small businesses
tend to start off with the Cash Method of Accounting
because it's easier to apply and it's a good way to track cash flow.
However, if and when those businesses continue to grow
there may come a point where it makes sense to make the switch to the Accrual Basis of
Accounting instead. That's all for today
thank you for watching if you found this video useful
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I'm thinking of doing some longer form videos where we were through some practice questions
and model answers to reinforce these ideas. If you think you'd find that useful
let me know in the comments below. I've had a great time learning with you today
Til next time!
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