3. Accrual Accounting Concepts
Accrual Accounting vs. Cash Basis Accounting
3. Accrual Accounting Concepts
Accrual Accounting vs. Cash Basis Accounting
Accrual Accounting is required by GAAP and is the main focus of this course. Cash Basis Accounting focuses only on cash transactions.
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Alright. So now let's consider the differences between an accrual basis of accounting, which is what gap requires and a cash basis of accounting, which is generally just easier to use, but it doesn't follow gap. Okay, let's check it out. So first thing let's consider something. The only way for us to really know the worth of our company. For us to truly know the worth. We would have to liquidate the company right? And liquidate that. That means to sell all the assets, right? Any inventory we have, we just have to sell it off any machines we have for production, we sell them and just get all in cash. Right? So our only asset is cash and then we pay off all our liabilities, everybody that we owe money, the banks, our suppliers and then whatever's left over, right, Whatever's left over is the company's worth. Right. That's really the true way to know what the company's worth. But obviously an ongoing company just can't liquidate. Right? So what we do is we use these financial statements, they act as progress reports for the company. Let me use this thinner pen. And I think it reports, I think the thinner pen looks a little nicer. Okay, progress reports. Right? So the financial statements, they come out periodically. Right? And that's what this time period concept has to do with when we do accrual accounting, which is what gap requires. Well, in accrual accounting we're gonna we're gonna report our accounting information at regular intervals. Right? And these are gonna be consistent. So generally these are gonna be yearly, right? Or monthly or quarterly. Right? It's gotta be some sort of consistent interval. And in this interval we want to understand what happened during that interval right at the beginning we'll have about balance sheet at the beginning of the interval that tells us the assets liabilities equity, right that we have and then the income statements telling us what happened throughout the interval, say throughout the year. And then at the end of the year we'll have a new balance sheet showing the new position of the company. Right? So that's the time period concept that we're dealing with in accrual accounting. Right? But we're just breaking up the breaking up the time into these years but the time doesn't stop right it's just constantly going. So the reason we break it up is for the reporting process. So let's first think about accrual accounting And remember accrual accounting. This is gap. Okay. Gap requires a cruel accounting. So what does it mean? Well accrual accounting records the impact of business transactions as they occur. Okay so there's gonna be triggering events that make us make a journal entry or make some sort of record that this event occurred. Okay so with accrual accounting you're gonna see that every time there's some sort of event we're gonna make a journal entry. And let's think about revenue as well. So when we make a cash sale in accrual accounting. Well this was an event, right? We delivered our product, we did our job We're gonna make a journal entry, right? We're gonna make a journal entry. I'm gonna put J. E. For journal entry. And I'm also gonna put revenue right here because we do earn revenue at this point. Same thing with a credit sale right now this is what's gonna be different from a cash basis. So notice here in a cruel accounting when we make a credit sale this means that we give the customer the product but they didn't pay us yet. Right? We let them pay us. Later on we gave them say a month to pay. So when we make a credit sale in accrual accounting, we did our job. We gave the customer the product. We earned our revenue. Okay so we're gonna make a journal entry and we're going to earn revenue in this case. Okay now how about when we received the cash from that credit sale? Right. We made this sale let's say now a month ago. And now finally the customers paying us. Well now when the customer pays us this isn't a revenue entry, we took the revenue for this. When we gave the customer the product. Right now it's just a cash collection. This has not nothing to do with us earning the revenue. But we still make a journal entry. Okay this journal entry. It's going to be about accounts receivable. Right? We have some account receivable some money owed to us and we're collecting that account receivable. Right? So there's no revenue. There were just collecting an account receivable. How about when we pay our employees when we make a payment to our employees, we're gonna make a journal entry and generally this payment, well, it's going to get rid of the liability of the money we owe to the employees, right? There's money the employees work for us. And while they work for us, they're accumulating earnings right that we have to pay to them. So eventually when we pay them, this is us finally paying them and getting rid of that liability that we have right, we have this liability to pay these employees. So we're going to get rid of it, right? And this generally with with employment expenses, we're gonna get we're gonna get to this a little more and we'll deal with it in a little more detail. So you'll you'll see more details about that later. But just the idea that when they work for us, we're gonna get rid of this liability write of us owing them money when we finally pay them okay. And the last but not least. This is another trick with a Cruel County. So think about when an employee works, Let's say they had a pay day on January 28 and they kept working the next three days of the month, January 29, January 30, January 31. But we didn't pay them for those days yet. Right? So we have to accrue an expense for those days when we're doing accrual accounting, right? Let's say we're going to report our income statement on January 31. We last paid the employee on the 28th. Well he did work for us those three days on the 29th, the 30th and the 31st. But we didn't account for it in this period, right? Because our last payment to them was the 28th. We made a journal entry on the 28th but they kept working. So these three days we actually have to make a journal entry here and we're gonna learn more about these journal entries um to accrue this expense. Okay. For those three days, even though we didn't pay any cash, right? They worked for us those three days. The pay dates coming up someday in the future and we're gonna have to pay them on that future date. Right? But those three days that they worked this month, we have to accrue that expense this month. Okay. So we go into a lot more details about all of that uh throughout this unit. But I just want you to notice that all of these events are triggering for a journal entry. Right? We had to make a record in all of these cases. So let's go ahead and pause here and then we'll continue with the cash basis accounting and see how these same transactions are dealt with in the cash basis. Cool. Alright. So let's pause and we'll continue the rest of the sheet.
Cash Basis Accounting
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Alright. So now let's consider those same transactions from a cash basis. All right. I want to note real quick that this is not gap. Okay, so this does not follow the required standards in the United States are gap and this is not part of those standards. The reason we still study it and still learn it is because this is an easy model that's still used by a lot of businesses, especially small simple businesses. When I was when I had my tutoring business of just doing private tutoring. Well I just used the cash basis of accounting, right? Because it wasn't so complicated whenever my customers paid me. Well that's when I earned my revenue. Okay because it was just a simple business and that's that's the difference here. Is that everything in a cash basis is only impacted when cash is involved. Okay. So we only record the impact of cash transactions. Okay. So only when there's cash movement, will we make a journal entry? So when we make a cash sale? Yes, we're gonna make a journal entry here and that is gonna be revenue. Right. So I did a tutoring session and the student paid me at the end of the session in cash boom. I make my journal entry. I earned my revenue. Now what about a student? He comes to me and I tutor him for two hours and then he's like, oh let me pay you next time. Alright well in a cash basis of accounting. Since he didn't give me the cash yet. We don't record revenue. There's actually no journal entry that's going to be made at this point. We're not gonna uh credit and a account debited accounts receivable or anything like that. There's nothing like that. We're not accruing anything in a cash basis, right? Notice a cruel accounting. We're accruing things like a receivable or a liability. Things like that. Where in a cash basis, we don't make this journal entry for the credit sale. When we do make the journal entry is when we receive the cash notice, we're receiving the cash from that credit sale. Well now we make the journal entry to earn our revenue. Okay. Something that would be like we debit the cash and credit the revenue. Okay. And how about when we pay employees when we pay the employees in cash? Yes, we're paying them in cash. We're excuse me, we're gonna make the journal entry, right? And this will create an expense. We would do something like debating wage expense and crediting cash, right? We credit cash to lower the balance and debit the wage expense to increase the expense there. And the last one here with those three days at the end of the period, right? We were discussing that, let's say the Employee got paid on the 28th. But they also worked the 29th 30th and 31st of the month. And then we released our financial statements. Well from a cash basis, it doesn't matter if the cash didn't move. There's no journal entry. We're not gonna make any sort of a cruel for those three days. So you can see how in a cruel basis of accounting does a better job of matching all those expenses, right? He worked those three days. Well, we're gonna take the expense even though we didn't pay him in cash yet. Right? So that that expense will show up on the income statement for those three days and then we pay him in a later period. So that's the big thing about accrual accounting, is that the movement of the cash doesn't dictate when we do, when we take revenue or expenses, right? It's when the benefit uh is transferred. So for a revenue, when we deliver the product or complete the service for the customer, we take the revenue or for an expense. When we receive the benefit of whatever we're paying for, whatever we're getting. Once we receive that we gotta take the expense on that side. Right? From a cash basis, we just wait for the cash to move. So it's a lot easier in that sense. Alright, so that's about it. For the accrual to cash basis of accounting will also learn more about changing between cash and accrual as we study adjusting entries. Okay, so let's go ahead and continue on to the next video