We’re going to talk about some accounting basics and how to understand them. There’s two basic ideas in accounting. There’s cash versus accrual accounting and there’s double entry accounting, and I’m going to give a demo of what both of those mean and how to understand them. First, I’m going to show you cash versus accrual accounting. So on the top here, we’re going to demonstrate cash basis accounting. On the bottom here, we’re going to demonstrate accrual basis accounting. Let’s pretend that we’re in the wedding cake business, and we’re hired by a bride and groom to make a wedding cake. And they hire us in January, and in March, we deliver the cake.
Now, this may be a little bit of a stretch because you probably wouldn’t buy your supplies this early, but let’s just try to imagine. So in January, under cash basis accounting, we went out to the store and bought a whole bunch of cake batter and things and paid 50 dollars for those items. And that 50 dollars would be recorded in our financial books in January, when we went to the store and paid for those items.
Then in March, when we delivered that finished wedding cake and the bride and groom were happy and paid us for the cake, we would record that 250 dollars on our financial books. As you can see, these items are recorded in the month when they were paid for. However, under accrual basis accounting, even if we still went out and bought those items for 50 dollars in January, same scenario, we wouldn’t actually record the expense for those items until March, when we were paid for the cake. That way, the expense for the item would match the money earned for the item.
Expense and revenue is actually what it’s called. Next, I’m going to show you what double entry accounting means. Essentially, double entry accounting means that for every debit, you have to make a credit, and those things have to equal. So let’s say in that same wedding cake scenario, we bought 50 dollars of supplies. If we wanted to record that transaction in our general ledger, on the cash basis, we would record a debit of 50 dollars to expense and a credit of 50 dollars to our cash account. That means that we increased expense by 50 dollars and we decreased cash by 50 dollars. However, you see there’s two sides to that entry, and they total down to 50 dollars on the bottom. If we were recording this transaction on an accrual basis, whenever we bought the supplies in January, we would debit 50 dollars to a pre-paid account and then we would credit 50 dollars to our cash account. That way, the expense would not hit our income statement until March, when we actually delivered the wedding cake. In either scenario, you can see that there’s 50 dollars on each side of the entry. That’s double entry accounting.
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