Accrual basis of accounting
About this video
The same four months of catering are recorded on an accrual basis, where revenue and expenses are matched to when the service is performed. Money owed by customers becomes accounts receivable (an asset) and cash received in advance becomes deferred revenue (a liability). Profit becomes steadier, while the cash balance ends up the same as under cash accounting.
You'll be able to
- explain how accrual accounting matches revenue and expenses to when work is done.
- record accounts receivable and deferred revenue in the right places.
- calculate monthly accrual profit for the catering example.
- explain why cash ends up the same under both methods.
Key words
- Accrual accounting
- Recording revenue and expenses in the period when the service is actually performed.
- Accounts receivable
- Money customers owe you for work you've already done; it's an asset.
- Deferred revenue
- Cash received in advance for work not yet done; it's a liability until you earn it.
- Asset
- Something that gives you future benefit, like cash or money owed to you.
- Liability
- Something you owe to others, like money or a service you must still provide.
Transcript
Let's now account for the same series of events, but instead of doing it on a cash basis, let's do it on an accrual basis. And the whole idea with accrual accounting is to match your revenues and expenses to when you actually perform the service. So it actually captures business activity, as opposed to just capturing when cash changes hands.
So let's see what that actually means. So in month one, you cater an event where the cost to you was $100. The customer pays you $200 for your services. And what I'll do, I'll do the accrual accounting right here. So this is kind of the cash income statement. Let's do the accrual accounting income statement.
So you actually provided the service of catering, you got $200 for your services. So I'll put $200 in for revenue. And the expenses associated with that service that you provided in month one is $100. And so your profit is $100. So at least for month one, the cash basis and accrual basis of accounting look exactly the same.
And once again, you have $100 in cash. Now let's go to month two. You cater an event where the cost to you was $200. You and the customer agree that they can pay you $400 the next month. So now it gets interesting, because you performed the catering that month.
And the catering that you performed that month is worth $400. So in the accrual basis of accounting, would say that you earned $400 of revenue, even though the customer did not pay you. They did not give you the cash. And the way that you account for that, is on your balance sheet you say that you are essentially owed $400.
So this accounts receivable, this is essentially stuff that other people owe you. You need to receive this from other people. But it's an asset. Other people have an obligation to you. So you have an accounts receivable of $400. When they pay you the $400, it goes from accounts receivable to cash.
And then the cost to you was $200. So here, all of a sudden, you performed the service, the revenues and expenses for that service are in that month. And now your profit here shows $200. So it is actually a better reflection of what you did it that month. Now, the reality is that you didn't get the cash for it, and you had to spend $200 of cash out of your pocket.
So you're still, just like the cash accounting, you're still going to have negative $100 in cash. Now, let's go to month three. You get $400 from the customer the previous month. Now with cash basis, you would have added that to your revenue. But here we already accounted for it in the accounts receivable.
We already took that revenue, but because you got the $400 in cash, it's going to just disappear from receivables and then go into cash, because you actually got it. You get $400 from the customer the previous month. You also get $200 in advance from a customer that you have to cater for the next month.
So you did no catering in month three, and because you did no catering in month three, you have zero revenue in month three. And then you also have zero expenses. The way that you account for the $400 that you got, is that your accounts receivables goes to 0. And that goes to cash.
So the negative $100, you add $400 to it, so it will become positive $300. And the way that you account for this $200 in advance from a customer, is you call that deferred revenue. You've got the cash there. So we went from negative $100, added $400 to $300. You get another $200 in cash, so that gives us $500 in cash again.
But we didn't earn any revenue. That $200, that was a kind of a cash advance. So we put that right over here in deferred revenue. That's revenue that we're deferring to a future period. In the future, we will earn it. This is now a liability, because we are obligated to earn that revenue.
And then in month four, we actually earn the revenue. So in month four, we can actually put it on our income statement at $200. And then we had $100 of expenses. So we have this $100 right over here. And so in month four, we earned $100. And once again, $100 went away from our cash balance.
So we still have $400. So whether you do the cash basis or the accrual basis, you have the same exact amount of cash. But what's more interesting is how the profit relates in each of the periods. And I'll talk about that in a little bit more depth in the next video.
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