Track 1 · What accounting does
Accrual versus cash accounting
Accrual accounting records revenue when earned and expenses when incurred. Work through why accrual profit differs from cash flow.
You will be able to
- Measure revenue and expenses on an accrual basis.
- Compute net cash flow for the same period.
- Explain why the two differ and why the accrual basis is required.
Builds on
Related standards
Conceptual Framework 1.17 · IAS 1
There are two ways to decide when something counts.
Under cash accounting, revenue is recorded when cash comes in and expenses when cash goes out. Under accrual accounting, revenue is recorded when it is earned (the work is done or the goods delivered) and expenses when they are incurred (the resource is used up), whenever the cash happens to move.
Financial statements prepared under IFRS Accounting Standards (and US GAAP) use the accrual basis; the Conceptual Framework explains that it shows the effects of transactions in the periods in which they happen, which says more about performance than cash timing does. Cash timing is easy to move — delay paying suppliers, or bill customers early — so cash on its own is a poor measure of how a business performed in a period.
How to think about any item
Ask two separate questions:
- Which period earned the revenue or used the cost? That decides profit.
- When did the money actually move? That decides cash flow.
When the answers differ, the accounts carry the gap in the statement of financial position until it closes:
- earned, not yet collected → accounts receivable (an asset);
- collected, not yet earned → unearned revenue (a liability);
- paid, not yet used → a prepayment such as prepaid rent (an asset);
- used, not yet paid → an accrual or payable such as salaries payable (a liability).
Profit isn't "better" than cash or vice versa: owners and lenders need both. A profitable business can still run out of cash if customers pay slowly, and a business with a full bank account can be making losses.
| Client work done and invoiced in April | 13,000 |
| …of which paid in April (Pepper & Sage's menu, paid on the spot) | 650 |
| Paid in advance by Ostrander Gym for work in May and June | 1,500 |
| Salaries earned by Maya and Theo in April (22 working days) | 6,600 |
| …of which paid on 17 April (the rest is paid on 1 May) | 3,900 |
| Rent paid: April's on 1 April and May's in advance on 28 April | 1,600 |
| Insurance paid on 1 April for 12 months | 2,400 |
| Other April costs used: supplies, electricity, repairs, advertising, bank fee, loan interest | 1,680 |
| …of which paid in April (the rest is owed to suppliers, less supplies still on hand) | 910 |
| Depreciation: April's share of the equipment's cost | 175 |
The shareholders' 20,000, the 18,000 bank loan and the equipment purchases also moved cash in April. They are financing and investing, not the running of the studio, so they are left out here.
| Item | Accrual profit | Cash from running the studio | Gap carried in the balance sheet |
|---|---|---|---|
| Client work | 13,000 | 650 | Receivables 12,350 |
| Ostrander's advance | 0 | 1,500 | Unearned revenue 1,500 |
| Salaries | (6,600) | (3,900) | Salaries payable 2,700 |
| Rent | (800) | (1,600) | Prepaid rent 800 |
| Insurance | (200) | (2,400) | Prepaid insurance 2,200 |
| Other costs | (1,680) | (910) | Payables, less supplies still on hand |
| Depreciation | (175) | 0 | Equipment cost not yet used up |
| Total | 3,545 | (6,660) |
Brackets show deductions. Every figure comes from Lumen's ledger.
Accrual profit for April counts what April earned and what April used up: revenue 13,000 less salaries 6,600, rent 800, one month of insurance 200, other costs 1,680 and depreciation 175 = 3,545. Lumen made a profit in its first month.
Cash from running the studio counts money in and out of the bank for day-to-day work: 2,150 came in and 8,810 went out, so the studio used 6,660 of cash.
Both figures are right. The 10,205 gap is timing, and each piece of it sits in the statement of financial position at 30 April: work done but not yet paid for (receivables), cash received for work not yet done (unearned revenue), rent and insurance paid for months still to come (prepayments), salaries earned but not yet paid, and bills not yet settled. A new business that invoices on 30-day terms and pays for cover in advance usually looks like this — which is why it needs the owners' money and the bank loan to get through its first months.
Practice
Practising as a guest — attempts aren't saved.
Exercise 1 · Calculate
Using Lumen's April figures above, what is April's profit on the accrual basis?
Exercise 2 · Calculate
What was Lumen's cash from running the studio in April? Leave out the shareholders' money, the bank loan and the equipment purchases, as the figures above do. Enter an outflow as a negative number.
Exercise 3 · Classify
For Lumen's April, does each item affect April's accrual profit, April's cash, or both?
Exercise 4 · Concept check
Why do financial reporting frameworks require accrual accounting rather than cash accounting?
Exercise 5 · Concept check
Marigold Bakery reports a healthy profit for the quarter, but its bank balance has fallen and it is struggling to pay suppliers. Which explanation fits?
Exercise 6 · Worksheet
Sparrow Tutoring's July is below. Complete the worksheet: the effect of each item on July's accrual profit and on July's net cash flow. Enter deductions as negatives and 0 where there's no effect.
Exercise 7 · Calculate
In June a shop sells goods for 14,000: 10,000 for cash and 4,000 on credit. It also collects 3,000 owed from May sales. The goods sold cost 8,500, all bought and paid for in May. June wages of 2,000 are paid in June, and a 600 June utility bill will be paid in July. What is June's accrual profit?
Key points
- Accrual accounting records revenue when earned and expenses when incurred.
- Cash flow and profit differ because of timing; the gaps sit in receivables, payables, prepayments and unearned revenue.
- General-purpose financial statements use the accrual basis.
- A profitable business can still run short of cash — watch both.
Content review: answers and figures are checked by automated tests against the accounting engine, and the text has had an internal review against the standards; independent review by a qualified accountant is pending.