Accrual basis of accounting | Finance & Capital Markets | Khan Academy


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.

25 thoughts on “Accrual basis of accounting | Finance & Capital Markets | Khan Academy

  1. 4.37 time, i didnt understand the last part.month 4, we earned profit $100, adding previous month cash $500, how did we get to $400,…and not $600.

    thanks

  2. Why in the third month don't we recognize any profit? Since we agreed on the future catering and received a prepayment, aren't we supposed to make profit in this month?

  3. On Month 3, he counted the $200 advancement as cash, but I thought in Accrual Basis, you don't count the cash until the service is provided. So wouldn't that keep the cash balance for Month 3 at $300? Then when we convert the Deferred Revenue to actual Revenue in Month 4, the cash total will still become $400. Right?

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