[MUSIC] In this video, we're going to answer to the question of whether it is better to use accrual accounting or cash accounting to measure the performance of the firm. We are going to do this by means of a mini example. In period 1, company A purchased inventory for total value of 100 euros. In period 2, company A sells all of this inventory for 200 euros. Let's assume that there isn't any other transactions in this business. If the company used cash accounting, in period 1, the company would recognize a cash profit of minus 100 euros because there was a cash outflow at the moment of paying this purchase of inventory. In period 2, there's going to be a cash profit of 200 euros because the company selling this inventory and is getting the cash of 200 euros. If instead of cash accounting the company was using accrual accounting, in the first period the company wouldn't record anything because just purchase an assets paying cash. So the shareholders of the company are neither richer or poorer. They just have changed one asset cash for another asset, inventory. In period 2, though, the company's selling this inventory, so inventory's going to go down. We'll have to recognize the cost of the good salt. And on the other hand we have receiving this because we are selling the product, and therefore we are receiving the price of this product, the 200, and so the overall profit is going to be 100. Note that in both methods the total sum of profits is going to be the same. In other words, a liquidation of a company, the total profits in the history of the company are going to be the same as the total change in cash in the life of that company. This is because at the end of the day remember that profitability and liquidity are related. Sooner or later all these revenues and expenses are going to have an impact in cash. So the difference between cash accounting and accrual accounting is a miss match in time. It is a matter of allocation over time of all these revenues and expenses. Note that if we add the total amount of profits and they're both methods, we are going to get the same total amount, 100 years. In other words, a liquidation of a company, the total amount of profits in the history of this company equal the total change in cash in the history of the company. This is the case because obviously profitability and liquidity are related. At the end of today, you expect to collect the revenues and you expect to pay the expenses. And so, the differences that we are finding between cash accounting and accrual accounting have to do with an allocation of our time, so it is a mismatch in time. Now, the question is, if under both methods the total profit at the end of the life of the company is the same, why using accrual accounting? Well, let's continue with the example. So you were a shareholder in this company, and this company was reporting according to cash accounting, what would you think of the resulting the first year of the company? You're thinking this is a disaster. But probably that's not an accurate picture of what's going on in the company. Because the case is that the company still has that inventory with a future value and the company expects to sell that inventory in the next period. Now, if you take the result of this company in the second year, you will think this company is great and they have 100% margin. Well, that wouldn't be an accurate picture of the company either. Why? Because in order to generate these 200 of sales, you have to incurring a cost of 100. So here there is a sort of mismatch, a misallocation over time. However, with accrual accounting, as you will see, there is a matching between the revenues and the costs associated with those revenues. Therefore, if you wanted, as a shareholder, you want to value this company, if you wanted to make forecasts of the profit of this company in the future or forecasts of the cash flows of this company in the future, which method would you prefer? Under cash accounting you would have a lot of fluctuations year to year, it's very difficult to forecast the cash flows in the future. Because you don't have a clear association between the revenues and the cost associated with those revenues. However, with accrual accounting, you have that association. So you know that if next year you expect to sell 400, most likely, your cost of goods sold are going to be around 200. So clearly accrual accounting helps you to make better forecasts of the future, and so this is useful for shareholders. So this matching between revenues and expenses that takes place in accrual accounting is very helpful for forecasting and for volume companies. Now, let me give you another reason. Let's say that you're the manager of this company. Now, if you were compensated according to the profit of the company, and the company was using cash accounting, then, probably you would never make like long term investments. You wouldn't purchase the inventory now. You would just purchase the inventory at the moment you have to sell it. But the simple capital with machinery for example, you will never dare to make a big investment in machinery, because that would penalize big time your cash, and therefore, you will have very negative profits in the beginning. So you won't get compensated. You won't get any bonus. So accrual accounting is also important for contracting. Finally, let me just mention one disadvantage of accrual accounting. The problem of accrual accounting is that many times you have to make estimations over time, for example, depreciation. You're making an estimation of the loss of value of an asset over time, so the allocation that you make of this cost over time is sort of subjective. You try to make your best guess. But many times you will make mistakes in the estimation, or many times even some people might manipulate these numbers. So Accrual Accounting gives you profits that are estimations, whereas Cash Accounting gives you a calculation of the real cash. We're talking about real cash inflows and outflows. So there is no doubt about it. In the next video, we're going to see a few examples of accrual like camping at work. [MUSIC]
