Timing is everything¶
A company can collect a pile of cash this month and still report a loss. Another company can collect nothing and still report a profit. That isn't a trick and it isn't fraud. It's timing, and by the end of this section you can tell the difference every time.
Netflix's billion-dollar timing problem¶
Netflix pays billions of dollars up front for shows it will stream for years. When a new season drops, has Netflix incurred an expense for it, all of it, some of it, or none of it yet? Nothing changes hands at month end, and yet the answer decides whether Netflix reports a profit or a loss for the period. That's the question this whole chapter answers: not whether a business did well, but which period a number belongs to.
Every business hits this question at the end of an accounting period, the stretch of time (a month, a quarter, a year) that one set of financial statements covers. Chapters 1 and 2 built the books for transactions as they happened during a period. This chapter is about the moment right after the period ends, when a business has to decide what it actually earned and spent during that stretch, even for the events where the cash hasn't caught up yet.
Two ways to keep score¶
There are two honest ways to measure a month's business, and they can land on different answers for the exact same events.
Cash-basis accounting records revenue when cash comes in and expenses when cash goes out. It's simple, and it's probably how you track your own bank account. It is not, however, how GAAP allows companies to report.
Accrual-basis accounting records revenue when it's earned and expenses when they're incurred, no matter when the cash moves. Two rules make that precise. The revenue recognition principle says revenue is recorded when the performance obligation is satisfied: when the business has actually done what it promised the customer, not when the invoice gets paid. Expense recognition, often called matching, says an expense is recorded in the period it helps generate revenue, not the period it happens to be paid for. GAAP requires the accrual basis because it measures what a business did during the period, not just what its bank balance did.
That gap between "cash moved" and "the work happened" shows up in four patterns you'll see for the rest of this course.
| Situation | Cash this period | Revenue or expense this period |
|---|---|---|
| Customer pays Juniper Web Design in advance, work not started | Cash in | None yet. It's a liability called Deferred Revenue (some people still call it unearned revenue) until the work is done |
| Juniper Web Design finishes a site and bills the customer later | None yet | Revenue now. The unpaid amount becomes Accounts Receivable |
| Juniper Web Design pays for a year of software up front | Cash out | None yet. It's a prepaid asset until it's used up, month by month |
| Juniper Web Design uses electricity all month, bill not paid | None yet | Expense now. The unpaid amount becomes a payable |
Common mistake: revenue means cash in the register
It's tempting to think revenue happens the moment cash lands in the account. Under accrual accounting it doesn't. A customer's advance payment is Deferred Revenue, a liability, until the business earns it by doing the work. Meanwhile a job that's finished and billed to the customer is revenue right now, even before the cash arrives, and the unpaid amount sits in Accounts Receivable until it's collected.
Same events, two different bottom lines¶
Because cash and accrual accounting can put the same event in different months, the two bases can produce different net income for the same period, even though they're describing the exact same underlying events. Neither number is wrong. They're answering different questions: cash-basis net income tracks the bank account, and accrual-basis net income tracks the business's actual performance.
One event, two numbers
Willow Creek Yoga teaches $600 of classes in June for a client who pays in July, and also collects $500 in June from a client who paid in advance for classes it will teach in July. Cash-basis revenue for June is $500 (only the cash that arrived), while accrual-basis revenue for June is $600 (only the class that was actually taught). Neither figure is a mistake. They're each doing what their basis is designed to do.
That's why an increase in cash during the month doesn't automatically mean a profitable month, and a shrinking cash balance doesn't automatically mean a loss.
Sorting out which period a dollar belongs to is exactly the job of the adjusting entries the next section builds, starting with cash that was paid or collected before the work happened.
Pause and work¶
Try the full comparison yourself: given a month of events, work out both net income figures side by side.
The cash-basis side is already filled in below. Work out the accrual-basis revenue, expenses, and net income yourself.
Now try a fresh company and a fresh month, start to finish.