1. Cash vs. Accrual Accounting

Let's talk about revenue recognition. When should we formally record? So when should we formally record the fact that we've gotten revenue? Well, it depends. So there are two basic schools of accounting. There's cash accounting and accrual accounting. And for the rest of your class, you're gonna be talking mostly about accrual. Cash is pretty simple. Accrual is what most big companies actually use. So on the cash side, everything is based on cash.

So you recognize revenue when you get cash. So if we've got a simple little timeline here, let's say you agree to do work, then you do the work, then you get paid. According to cash basis accounting, when would you recognize the revenue? Well, you would recognize it all the way over here when you get paid. So under the cash basis of accounting, you don't actually record any revenue at all until you get paid. Well, so what's the accrual basis of accounting? Accrual is based on the work.

You recognize revenue when you earn it. So in accrual accounting, you agree to do the work, you do the work. This is where you recognize it under accrual. And then when you get paid, you don't recognize any more revenue because you earned the revenue back when you did the work. And so the difference between cash and accrual is with cash, it's all based on cash. There's nothing else that you have to remember. Money in equals revenue, money out equals expense.

Now, on the accrual side, revenue equals earned, and expense, you recognize it when you incur it. And so that leads us to some interesting use cases. So let's take a look at rent. And let's say you have January 1, and you've got December 31, and you pay $12,000 a year or $1K a month.

So you pay $12,000 per year, and you pay it on January 1. So at the very beginning of the year, you have to pay $12,000. Now, let's assume we're the landlord. We get paid $12,000 on January 1. Under cash basis accounting, we would recognize $12,000 of revenue on January 1, right? Because we got paid, and all that cash basis accounting cares about is cash. So we would recognize $12,000 January 1 because we got paid on January 1. Now, if we are doing accrual accounting, we haven't done any work. And here, the work is letting the person live in the house, right?

We haven't earned any of it because they paid for this whole year, and we owe them this whole year. We haven't recouped or we haven't earned any of that rent yet. And so under accrual based accounting, we're gonna have to recognize this $12,000 throughout the year.

So under the accrual basis of accounting, we've got February, March, April, May, June. We've got 12 months here. And as time goes on for each month, let's get rid of some of this. As each month goes on, we're going to recognize a little bit more of the revenue. So after January is over, we've earned $1,000 of that revenue.

After February is over, we've earned another $1,000. Same for March. Do you see how we're earning it as we go along? We've provided the place for this person to live each month as we're going along. So as we go along, we are earning this rent. And at the end of the year, we've earned it all. So cash when collected.

We recognize revenue under the cash basis when we collect it, when we get it. Now, for accrual, we have to wait until we earn it. And you can think of this like, let's say you're allowed to get out of your lease right here. So we've lived there now for one, two, three, four, five months.

So we've lived there for five months. That means we still have seven months remaining that we paid for up front, but we didn't actually live there. Wouldn't you feel like this seven months, this $7,000 is your money, not the landlord's money? Because you haven't lived in the house for this seven months. So you would feel like, "Hey, I'm still owed that $7,000." Now, why would you feel like the landlord is okay keeping this $5,000? Because for this five months, they gave you a place to live. They earned it. They earned that $5,000 by providing you a house to live in.

But this $7,000, they haven't earned yet. For this seven months, they haven't provided you a place to live, not yet at least. So if you got out of your lease right here, then they have an unearned seven months. So they don't get to recognize that as revenue. This is the important part right here.

On cash basis accounting, it's when you collect it. On accrual basis accounting, it's when you earn it.