Cash vs. accrual

- [Instructor] So now let's turn our attention to a very important topic in understanding financial statements, cash versus accrual accounting. At a high level, the cash basis of accounting is a lot more popular with small businesses, and as we'll soon see, the accrual basis is more popular with larger businesses, especially those with outside investors. But what exactly do they mean? Well, let's start with the cash basis. The cash basis specifically focuses on how much money entered your business and how much money exited your business. This is a method for recording financial transactions based off of these events as shown in your financial statements. The cash basis is exceptionally popular given the fact that the recognition of transactions is very easy. You simply record your income when cash is received and expenses whenever you paid your actual expense, regardless of when the activity takes place. It's also popular given how simple it is. It's a lot more straightforward to manage the production of your financial statements under the cash basis because all you need to do is tag the transactions as they flow through your bank account. The cash basis is also popular given the way that it works with timing. It provides a real time view of your cash flows, as it reflects the actual cash position of your business at any point in time. Lastly, there are also tax implications involved with the cash basis, which can leave it favorable in the event that, let's say, you delay a payment that you would otherwise have to make on taxes under the accrual basis. Now I'll explain a little bit more about what I just said when we get to the accrual basis, but first, just like there are benefits to the cash basis, there are also challenges. The biggest one is the fact that the readers of the financial statements may not truly understand what is happening in the business. All they can understand is how much cash is entering or leaving the business. Additionally, the cash basis of accounting is not compliant with what's known as Generally Accepted Accounting Principles, or abbreviated for GAAP. We'll talk a little bit more about GAAP versus IFRS in our next module, but for now, just know that GAAP is a mechanism in which many US-based companies record financial transactions according to the rules set by GAAP. Let's now turn our attention to the accrual basis of accounting. The accrual basis of accounting is a little bit different than the cash basis. Instead, it focuses on when exactly your income is earned compared to when exactly your expenses are incurred. Now when I say incurred, I in essence mean consumed, so as you can see, this is fairly different from the cash basis, which only cares about the cash that enters and leaves your bank account. The accrual basis is popular for a number of reasons, starting with the way transactions are recorded. Here, you're recording transactions based off of the actual business activity, income whenever it gets earned, i.e., you deliver your product or service to your customer, and expenses whenever they are consumed. The accrual basis is also popular given that there is additional complexity. A controller that's tasked with closing out the books and managing the production of financial statements each month for a company will have more complex entries to make under the accrual basis of accounting. The accrual basis of accounting is also really good at matching transactions. The idea is that any expenses should be matched with the period in which the income that it was incurred. This is called the matching principle and is a term you may hear as you learn more about the field of accounting. The accrual basis is also helpful in that it allows companies to stay compliant. Like we mentioned earlier, the cash basis does not allow you to record your financial statements under that method of accounting. Instead, larger companies that follow GAAP must use the accrual basis of accounting. But just like there are benefits and challenges to the cash basis, there are also benefits and, more importantly, challenges to the accrual basis. The biggest challenge that I've seen with the accrual basis of accounting is the fact that the actual time to produce financial statements and reconcile transactions take longer. Instead of just classifying transactions when they enter or leave your bank account, you instead are recording those transactions as actual activity takes place. That requires you to book a number of adjustments. In addition to that, businesses who charge upfront, say, for an annual contract, may have to pay more in taxes under the cash basis, but under the accrual basis, you'll be deferring those taxes, and because of that, you'll show poorer revenues. This is because on a 12-month contract, you'll only be able to recognize one-twelfth of the contract each month. Under the cash basis, you'll recognize it all upfront. Now that we're familiar with these two methods of accounting, let's turn our attention to the difference between GAAP and IFRS.