Lesson 1 of 8
One year, two answers
The same twelve months, measured on a cash basis and on an accrual basis, produce a loss of $11,800 and a profit of $61,600. Neither is wrong.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The same twelve months can produce a large profit and a large cash outflow, with no error anywhere.
- A cash basis answers "did money arrive" and an accrual basis answers "was value earned", and those are different questions.
- Published accounts use the accrual basis, which is why every set of them also carries a cash flow statement to bridge back.
Fen Street Bindery finished its first year with a profit of $61,600. It also spent $11,800 more cash than it took in. Both statements describe the same twelve months and both are exactly right.
The reason is that they answer different questions, and a reader who does not know which question is being answered will misread one of them.
One year, measured two ways
- Profit on the accrual basis$61,600
- Cash in, less all cash out including the machine−$11,800
The cash basis, computed
The accrual basis, and the four differences
Profit of $61,600 differs from the $36,200 of trading cash by $25,400. Four things cause it, and each will get a lesson of its own.
Revenue includes $40,000 of sales that customers have not paid for, because the work was done. The $9,000 deposit is excluded, because the work has not been done. Materials were charged at the $26,000 consumed rather than the $30,000 bought or the $24,000 paid for. Rent was charged at the $9,000 used rather than the $12,000 paid. And two costs were charged without any payment at all: $6,000 of depreciation and $600 of unpaid interest.
The machine is the separate $48,000. On a cash basis it is this year's outflow. On an accrual basis it is an asset that will be charged to profit over eight years, of which one year has happened.
Which question each basis answers
The cash basis answers whether the business could pay its bills this year. That is a real question and for a small business it is often the more urgent one.
The accrual basis answers whether the year's activity created more value than it consumed. It has to make estimates to do that, and every one of those estimates is a judgement someone made.
Public companies report on the accrual basis, and the reason is comparability across time. A business that happened to collect two large invoices in December rather than January would otherwise show a transformed year with nothing having changed.
Why both are published
A US company files an income statement on the accrual basis and a cash flow statement that starts from profit and reconciles to cash. The second exists precisely because the first contains estimates.
That reconciliation is the most useful list in a set of accounts and hardly anybody reads it. It is the company's own itemisation of every accrual it made, printed in its own filing, and lesson seven of this course adds it up across ten years of a real one.
The trap this sets for a reader
A company can be profitable and run out of money, and the mechanism is visible in the numbers above. Fen Street Bindery earned $61,600 and has $40,000 sitting in customer promises it cannot spend. A business growing quickly does this at scale: every new sale ties up cash in receivables and materials before it collects anything.
The reverse also happens. A company can report a loss and generate cash, which is the ordinary case for one carrying large depreciation on assets bought years ago. The charge is real, the money left long ago, and this year's cash is unaffected by it.
Neither pattern is good or bad on its own. Both are reasons to read the reconciliation rather than either figure alone.
Check yourself
A company reports a profit and a fall in cash for the same year. What follows?
- One of the two figures is wrong
- Nothing yet. The two answer different questions and can legitimately disagree by a large amount
- The company is failing
Show the answer
Answer: B.
Uncollected sales, prepayments, unused materials, depreciation and asset purchases all separate the two. A gap is the normal case and its composition is the interesting part.A customer pays $9,000 up front for work starting next year. How does each basis treat it?
- Both count it as this year's income
- The cash basis counts it now, the accrual basis counts it when the work is done
- Neither counts it until the cash is spent
Show the answer
Answer: B.
Cash received before the work is a liability on the accrual basis. It becomes revenue only as the obligation is discharged.Why do public companies report on the accrual basis?
- It produces higher profits
- It makes periods comparable, since the timing of payments would otherwise dominate the result
- Cash figures are unreliable
Show the answer
Answer: B.
Collecting an invoice a week earlier would otherwise move profit between two years. The cost of comparability is that estimates enter the accounts, which is what the rest of this course is about.Sources
- This lesson is taught from first principles on the worked example built in the bookkeeping course. No external source is cited.
What this leaves out
- Fen Street Bindery and every figure are invented, chosen so both bases can be recomputed by hand.
- A true cash basis would also ignore the loan and the share issue as financing rather than trading, and treat tax differently. The version here isolates the trading comparison.
- Very small US businesses may use a cash basis for tax purposes. No SEC registrant may use it for its financial statements.
- Nothing here is advice about any security.