Thursday, August 18, 2022

Accrual Accounting vs. Cash Accounting

Hi everyone in this video i'm going to walk you through an example of accrual accounting versus cash basis accounting let's take a look first up we're going to talk about the revenue side of things recognizing revenue under the two different accounting systems here i have an example where i tell you tiger dry.

Cleaners incurs the cost to clean customers clothes on june 28th the customers claim and pay for the clothes on july 3rd and in the middle of those tigers second quarter ends on june 30th so i ask you a few questions first what are the components of the transaction in other words what's the economic activity.

That's going on here that we're capturing second in which quarter should tiger report that economic activity and of course we're looking for revenue so you know that's kind of the economic activity you're trying to keep an eye out for but which quarter should they report.

That that that economic activity that revenue should it be in q2 which ended in the middle of this problem or should it be in q3 and so i tell you here um i want to know the answer under both accrual accounting and under cash accounting and i give you a hint that says draw timeline and so that's where i'm going to kick.

This off i'm going to draw a timeline that contains our activity and our key dates there's only three dates in this one those dates are june 28th july 3rd sorry july 3rd moves over and june 30 which comes between them all right there's our three key dates.

Now i'll talk about june 30th first june 30th there's no real economic activity going on that day it's just telling you second quarter is ending that day which means the period over here to the left of that is q2 the period to the right is q3 quarter two quarter three now if we focus on the economic activity on june 28th.

The company cleaned customers clothes in other words performed the service on july 3rd the customers collected their clothes and paid in other words paid.

For services or we should say i guess since this is from the company's perspective collected cash for services so there's our economic activity there's our key dates there's our timeline so now the question is q2 q3 where do you recognize revenue.

Let's start with accrual accounting under accrual accounting it does not matter when cash changes hands it's irrelevant we have to record when cash changes hands but that has nothing to do with revenue or expense under accrual accounting and.

Specifically the revenue recognition principle we say we get to record revenue when that revenue is earned by the company when do you earn that money when you perform the service so on june 28th when you perform the.

Service you have therefore earned revenue and therefore you will then record and report that revenue in q2 again this is under accrual accounting now cash basis accounting is very different cash basis accounting it doesn't matter when you're performing.

The service or fulfilling the obligation or earning the revenue under cash basis accounting cash is the only thing that matters so under cash basis accounting the day you collect the cash you are in essence collecting your revenue and therefore under cash basis.

Accounting you would report your revenue in q3 not q2 so there's the difference okay let's check this out even further we're going to use the same example but now we're going to look at the expenses rather than the revenue so here we go it's still tiger dry cleaners they still have that q2 end on.

June 30th only now we're going to focus on what are they spending to clean these clothes and we're just going to focus on two things one is the employees the employees are working june 16th to june 30th okay back half of june however they don't get paid until july 5th very common right you don't necessarily get your paycheck on.

The day you make the money you usually get your paycheck a week or two later there's a delay tiger's electricity bill for june so once again using electricity in june arrives in july and doesn't get paid until august and then of course we have the queue end on june 30th so same three question.

What's the components of the transaction in other words what are the economic activities and specifically with regards to expense and then when do we record those do we record them in q2 or q3 and once again i'm going to start off with a timeline so here's our timeline our timeline.

Actually starts on june 1 because our earliest date even though it doesn't say it is june 1 because of this electricity bill electricity bill for the month of june so starts june 1. we're gonna go all the way to june 30 because that's when the quarter ends so we have q2 over here q3 over here we are then going to proceed remember.

June 30 is the last day of june so july starts that day we're going to proceed all the way to then august so i'll call this august 1. and the main reason we need august in there as well is because we say that we do not pay the electricity bill until august so we need august on our timeline and of.

Course i'm going to just leave this open-ended because we don't have specific dates we don't ever hit september so i'm just leave that that end of the timeline open so here's our general layout we have june we have july and we have part of august q2 q3 both july and august are part of q3 a quarter last three months so.

Um those are both q3 all right let's fill in our dates so we know that the employees worked from june 16th to june 30th so i'm going to go ahead and add june 16th here in the middle and i'm going to put a bracket here that shows employees.

Worked we also know that the employees got paid on july 5th so i'm going to add in july 5th right here employees paid the other piece of this is the electricity all right we know that the electricity for the month of june.

So put a bracket here for all of june electricity used move my q2s and q3s down just to give us a little breathing room we know that the bill for the electricity arrived sometime in july we did not put a date on it so again i'm going to bracket july off.

E-bill arrived electricity bill arrived and then we know we paid for the electricity sometime in august so i'm just going to put this kind of open-ended bracket over here we don't know when in august but sometime in august ebill.

Paid so there's our entire timeline this one's a little bit more complicated than the one on the prior slide because we have two events going on that cover ranges of dates rather than just point in times so it it it becomes a little bit more messy but all the information's there it's all visual we can see it.

Let's do our two basis of accounting so first up accrual again just like revenue the expense recognition principle under accrual accounting says you recognize expenses when the cost is incurred not when the cash is paid when the cash is paid is irrelevant the.

Question is when did you become obligated to pay it when did you incur the cost well you incur the cost when the employees work and when the electricity is used so under accrual accounting cruel accounting cost was incurred.

In q2 therefore expense is recorded in q2 okay one of those would be salaries and wage expense that's your employees the others would be what we generally lump into utilities expense electricity is just one of your utilities.

On the other hand under cash basis accounting remember the cash is the only thing that does matter under cash basis accounting so under cash basis accounting we have the uh cash cost i'll call it incurred right or cash outflow i guess is what i should say outflow.

For both the employees on july 5th and then the electricity bill sometime in august remember both july and august are fully in q2 so the cash is the cash cost or the cash outflow incurs at those times so then under cash basis accounting this is when the expense.

Is recorded in q3 specifically july and then august it gets split between the two months all right now let's look at it in full summary and see what the main difference is from say an investor standpoint and why we might prefer one method over the other.

So here we go the only thing different in this slide is that i'm adding dollar values for you so i tell you that the um customers paid two thousand dollars for their dry cleaning i tell you that the electricity was 350 and that the employee cost was one thousand dollars and i'm doing that just so that we can then create these nice little grids and.

See the difference between cash accounting and accrual accounting so let's start with cash if you recall from our prior two slides under the cash method we recorded nothing in june we we didn't do anything in q1.

We recorded the 2000 payment from customers when they paid us in july we recorded the thousand dollars paid to our employees when we paid them in july and we recorded the 350 paid for the electricity when we paid it in august now what does this do from a business perspective remember all of this stemmed.

From activity that originally occurred in june but from a financial statement standpoint and from an investor standpoint june is showing no profit or loss in fact it almost looks like the company wasn't even in.

Business july is showing a thousand dollar profit okay that's great august is showing a 350 loss boy that sure doesn't look good and even more importantly than this look at how volatile this is we go from zero profit and loss to thousand dollar profit to 350 loss.

All from what was in essence the exact same set of economic activity wash some clothes get some money from your customers this is undesirable from a usefulness of financial reporting purpose the volatility does not give you an accurate assessment of what was the true economics of the business.

On the other hand accrual accounting notice we recorded the revenue when we earned it in june in q1 we recorded both the employee cost and the electricity cost when we incurred that cost in june in q1 for a net profit in q1 or june in this case of 650 and then we show no activity for july no.

Activity for august this is much more accurate of what happened remember the transaction the economics of the situation we washed the clothes for the customers using electricity and using our employees time all occurred in june and under accrual accounting we show.

That in june and what the net profit of that was in these two examples i didn't give you any economic um revenue or expense in july and august i didn't tell you what the company was doing as part of its ongoing business and so july and august are showing zero now in a real business what's going to happen is just like in.

June there's going to be new dry cleaning and new collections in july and there's going to be new dry cleaning and new collections in august right but this is going to give investors a much more stable less volatile portrayal of what does your ongoing business look.

Like it matches up your revenues and your expenses in the time period in which both were earned or incurred that's the benefit of accrual accounting over cash basis accounting so i hope you found this helpful and i hope you join me for another video

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