Hello, everyone. In our lesson today, we are actually going to introduce the basics of switching from the accrual basis of measuring performance to the cash basis. In other words, we are going to focus on the cashflow statement preparation. But we want to distinguish between the accrual basis which is used in preparing the income statement versus the cash basis that is used in preparing the cashflow statement. Our goal is to discuss the steps of preparing the cashflow statement in details. But before we get into the details of such preparation, we need to make sure that some questions are being addressed before we even start. A clear understanding of a certain number of questions, will make our task of repairing the cashflow statement much easier. Let's get started. First question, what is the difference between the cash basis and accrual basis in measuring performance? Simply stated, the cash basis is a match between cash inflows versus cash outflows while the accrual basis is a match between revenues versus expenses. Let me explain. The accrual basis presents a match between the amount of goods and services provided by an entity during a specific period, versus those goods and services that are consumed by the entity during the same period. That's basically what we call revenues versus expenses. On the other hand, the cash basis presents a comparison of the cash collected from operations, during a specific period, versus that cash that was paid during the same period. That's what we refer, cash inflows versus cash outflows. Very good. Second question, what is the difference between deferrals and accruals? Simply stated, accruals represent the exchange of services for which cash did not exchange hands yet, while deferrals represents the exchange of cash for which the service did not exchange hands yet. Let me explain. The accrual basis and cash basis will not differ. Have the exchange of the service or the good and the cash had taken place simultaneously. The conflict between the two bases would arise only when one exchange hands, but not the other. Accruals result from exchanging the goods and services and not the cash, so exchanging the goods and services. First, while deferrals arise as a result of exchanging the cash, but not the goods or services. Again, exchanging the cash first. From this comparison, we can define four important terms that will be used and are used quite a lot. First, two types of accruals. Second, two types of deferrals. Let's state the accruals first. Number 1, accrued revenue represent the value of goods and services provided by an entity for which the cash is not collected yet. Similarly, I think we can expect now what we can define or address accrued expenses. Accrued expense represent the value of goods and services consumed by an entity for which cash is not paid yet. That's the group of the accruals. What about the deferrals? Deferred revenue: deferred revenue represent the cash collected in advance for goods and services that are not provided yet. Again, you can expect how am I going to define deferred expenses. Deferred expense represent cash paid in advance for goods and services that are not consumed yet. Thus, accrued revenues and deferred expenses represent assets to the firm as they reflect expected future benefits. While the accrued expenses and the deferred revenues represent obviously liabilities as they reflect expected future sacrifice. Very good. We talked differences between cash basis and accrual basis. We talked the differences between accruals and deferrals. Let's get to the third and final question that I want to address in this lesson which is, what is the difference between the direct and the indirect methods in preparing the cashflow statement? Simply stated, the only difference is the operating activities sections only. Let me explain. A common feature between both of them have three sections. Both of them convert the accrual basis measurement in for measuring performance to the cash basis in the operating section. Both have identical investing and financing activities. Then basically what is the difference? The only difference is that in the direct method, we convert each revenue and each expense directly into its corresponding cashflow. While in the indirect method, we convert all the revenues and the expenses altogether that are hidden into their net income, to the net cash flow from operating activities, by converting the net income to the net cashflow from operating activities. In summary, to understand the structure of the cashflow statement, we need to know how the cash basis is different from the accrual basis used by accountants to measure financial performance in the income statement. As we mentioned in this lesson, the main difference between both basis for measuring performance is centered around the accruals and the deferrals. Understanding accruals and deferrals is a must. The accruals arise as a result of exchanging goods and services before the cash while the deferrals arise as a result of exchanging cash before goods and service. Thank you.
