Accrual Accounting is based on when the transaction occurs, rather than when cash is exchanged.
In other words…
- revenue is reported when it is earned and,
- expenses are recorded when they are incurred.
Let’s look at an example of Accrual Accounting.
When will revenue be reported?
Your company sells goods in January but isn’t paid until February.
If we were to use Cash Accounting, the revenue wouldn’t be reported until February when cash was exchanged.
If we were using Accrual Accounting, the revenue would be reported in January when the original transaction occurred.
A Common Question
“If Cash Accounting is so much easier, when do we even bother with Accrual Accounting?”
This is an excellent question. To better understand whey we use Accrual Accounting, let’s revisit an old friend from a previous lecture.
Remember Claudio from the Accounting Basics lecture? Historically, Claudio would travel to his supplier each morning to purchase decorative plates to sell to tourists.
This time, the manufacturer informs Claudio that he wishes to optimize his processes by eliminating the daily cash transactions. Because Claudio has been a loyal and reliable client, he wants to defer the daily cash transaction to a single transaction at the end of the week.
This introduces the concept of credit that will be given to Claudio in order to purchase the decorative plates throughout the week. This will allow for the settlement of purchased during the week to occur on Fridays.
For Claudio, this is a great deal. He doesn’t have to pay right away; he’s working with someone else’s money.
Claudio is now able to expand his business and purchase additional items from another manufacturer with his original cash-on-hand.
In the business world we call this the Leverage Effect.
Claudio decides to purchase 50 hats from a different vendor using his original 100 euros. He pays 2 euros for each hat and plans to sell each hat for 10 euros.
Once Claudio opens for business on the beach, now has 100 decorative plates and 50 hats for sale. The plates will sell for 5 euros each and the hats will sell for 10 euros each.
His friend Mario (who bears an uncanny resemblance to the seller of the decorative plates) really likes the hats Claudio is selling and wishes to purchase 30 hats for an event he is hosting this evening.
The catch is that Mario can only pay for the hats tomorrow after he has sold them at his event. Claudio agrees and hands over the hats to Mario.
Claudio stays at the beach and sells the remainder of his souvenirs and goes home at the end of the day.
Reconciling His Day
That evening, Claudio counts his cash in-hand and it comes to €700. He deducts his initial investment of €100 used to purchase the hats, leaving him with a profit of €600.
Is this correct? The answer is… it depends.
It depends on whether Claudio is utilizing Cash Accounting or Accrual Accounting. The key factor lies in the timing of when sales and purchases are recorded in the account.
Let’s run through Claudio’s day using each of these methods to see how they differ.