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Covering the differences with cash and accrual accounting
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There is a big distinction between
cash and accrual accounting.
0:00
Cash accounting is what you might see
with a classic entrepreneurial business,
0:05
like a small mom and pop store.
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They have the register which
holds all the cash and
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it goes up and
down when they buy and sell stuff.
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That's known as cash accounting.
0:18
Accrual accounting, which is the dominant
form of accounting on financial
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statements, seeks to present the financial
statements based on when revenue or
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costs are actually incurred,
instead of when the cash comes in and out.
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Accounting standards provide guidance and
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rules on how to handle these differences
in when the cash comes in and
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out, versus the actual underlying
economic reality of the business.
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In other words, how and when to recognize
or record certain transactions.
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I know that's confusing, especially for
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those of you who are being exposed
to this for the first time.
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Don't worry, that's completely normal.
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Let's talk through
an example using revenue.
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This is the money you
make from your customers.
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But you don't always collect the cash
at the same time you earn the revenue.
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There are lots of examples of this.
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I'm a doctor, and I see a patient who
pays me a fee for the check-up that day.
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I have earned the revenue for
that check-up, but
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maybe the customer doesn't actually pay
their bill until a month or two later.
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Or, let's talk about another example,
a gym membership.
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Let's say I signed up for
a two year membership, but
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I have to pay it all when I join.
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Let's call it $240 for two years.
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The gym wouldn't recognize that all as
revenue in the month that they collected
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the cash from me.
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They would recognize it over the two
years, earning $10 of revenue each month.
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Think about how much this
can vary by industry.
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What if we're selling planes or
building skyscrapers?
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Also, it's not just revenue
that can have timing issues
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based on when the revenue is earned.
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It also applies to expenses.
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Let's talk about depreciation.
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Depreciation is an expense that shows the
reduction in value of an asset over time.
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A classic example of this
is when you buy a car.
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Over time, it will reduce in value, unless
you bought a 69 Camaro SS or something.
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But how much does an asset
depreciate over time?
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Well, again, accounting standards provide
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guidance on different types of
depreciation methodologies.
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This difference between
when we actually pay for
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something and when items are earned or
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incurred is part of the reason why there
are three different financial statements.
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They each provide different
information about the business.
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Don't worry if this is confusing you.
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We're gonna cover this in the next stages,
and
2:54
it will make a lot more sense
after you've completed the course.
2:56
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