Accrual and Cash Accounting: One Year, Two Profits

Accrual accounting records a sale when the goods are delivered and a cost when it is incurred, whatever the bank account is doing. Cash accounting records both only when money actually moves. Because customers pay late and suppliers get paid late, one set of twelve months produces two different figures. Anjani Stationers earned Rs 38,00,000 on the accrual basis in year one while its cash fell by Rs 1,00,000.

Here is the idea underneath. Trading and settling are two separate events, and time sits between them. A business that recorded only money moving would look magnificent in the month its customers happened to clear their dues and desperate in the month it paid for a year of paper, and neither month would describe what the business actually did. Accrual accounting records the trading. Cash accounting records the settling. Both are honest, both are useful, and they disagree constantly.

The sections below work one year of one business under both bases, walk the eight lines that carry a profit of Rs 38,00,000 down to a cash movement of minus Rs 1,00,000 with no rupee left unexplained, and point at the place in the business where each missing rupee is sitting.

What is the difference between accrual accounting and cash accounting?

Start with a person rather than a business. A tuition teacher takes four batches through the whole of August. On the last day of the month she has done every hour of the work, marked every paper and earned every rupee of her fee. The parents pay on the fifth of September, the day their own salaries land. Ask what August was worth to her and there are two defensible answers: the full month of teaching she completed, or the empty bank account she was actually looking at on 31 August. Both answers are true, and each answers a different question.

Accrual accounting answers the first question by recording the trade at the moment the work is done, and cash accounting answers the second by recording only what the bank account did. Under the accrual basis the teacher earned her fee in August, and the fact that the money arrived five days later is a separate matter that gets recorded separately. Under the cash basis she earned nothing in August and everything in September. Neither system is lying. One is describing work, the other is describing money, and the difference between them is nothing more exotic than the gap in days between doing the thing and being paid for it.

Scaled up, the shape holds. Anjani Stationers is an invented printer of school notebooks and exercise books, working one small printing unit and one delivery van in a single city. Anjani Kulkarni started it and still signs the cheques; Meera Rao keeps the books three days a week. Every customer is a school. School offices work on their own clock, and schools pay in sixty to ninety days. So on 31 March, the last day of the Indian financial year, a very large quantity of notebooks has been delivered, used and written in, and a very large quantity of money for them has not arrived. The gap between notebooks delivered and money not yet arrived is the whole of the subject.

The vegetable cart at the end of the street has almost no gap between the two systems. Goods go one way, coins come the other way, and the seller's accrual figure and cash figure for a Tuesday are the same number. Push the gap out to ninety days and the two figures come apart. Push it out far enough and a business can be trading well and running out of money at the same time. Anjani Stationers did exactly that in year one.

When does each basis say the sale has actually happened?

Each basis has a trigger, and naming the trigger removes most of the confusion. Under the accrual basis, the trigger for revenue is delivery: the notebooks leave the unit, the school signs for them, the invoice is raised, and the sale is recorded on that date at that amount. The money owed is recorded at the same moment as receivablesMoney that customers have been billed for and have not yet paid. It is recorded as something the business has, because the right to collect it is real, but it is not money until it arrives., so nothing is lost, only separated. Under the cash basis, the trigger is the bank credit, and the delivery date is of no interest at all.

The two triggers usually fire in the same twelve months, and the ones that do not are what produce the whole difference between the two figures. A notebook order delivered in July and paid for in September fires both triggers inside year one, and nobody argues. An order delivered in the last week of March and paid for in May fires the accrual trigger in year one and the cash trigger in year two. Both orders run across the timeline below. The second one is the entire problem in miniature: the same trade, recorded in two different years depending on which trigger is being watched.

Why does the same twelve months produce two different figures?

Take Anjani Stationers' first year and write it out twice, changing nothing except the trigger. Year one runs 1 April to 31 March. The business billed schools Rs 2,40,00,000, every rupee of it on credit. The business bought paper and ink for Rs 1,32,00,000, also on credit. The store held Rs 16,00,000 of paper and notebooks on 1 April and Rs 22,00,000 on 31 March, so the cost of what was actually sold is Rs 16,00,000 plus Rs 1,32,00,000 less Rs 22,00,000. The cost of what was sold comes to Rs 1,26,00,000 and leaves a gross profitWhat is left of the sales figure after only the cost of the goods actually sold is taken off, before salaries, rent and every other running cost. of Rs 1,14,00,000.

Then the running costs. Salaries for the year were Rs 54,00,000, of which Rs 3,00,000 for March was still unpaid on 31 March. Rent was Rs 12,00,000 and was paid in full. Insurance of Rs 4,00,000 was paid on 1 October for the twelve months from that date, so only Rs 2,00,000 of cover belongs to this year and the other Rs 2,00,000 buys months that have not happened yet. DepreciationThe yearly charge that spreads what an asset cost across the years it is used. The van and the machine were bought and paid for in earlier years, so this year's charge moves no money at all. was Rs 2,00,000 on the van and Rs 3,00,000 on the printing machine. And the Sunrise Public School group had Rs 6,00,000 badly overdue, against which Meera Rao made a provisionAn amount set aside against money that has been billed but is now doubtful. It lowers the recorded profit and sets aside no cash, because nothing is paid to anybody. of half, Rs 3,00,000.

Written on the accrual basis the year made a profit of Rs 38,00,000, and written on the cash basis the same year moved the bank balance by minus Rs 1,00,000, and neither figure contains an error. The cash side is worked from the bank statement alone. The schools owed Rs 30,00,000 at the start, were billed Rs 2,40,00,000 during the year and still owed Rs 78,00,000 at the end, so they paid Rs 1,92,00,000. The paper suppliers took Rs 1,26,00,000. Salaries actually paid were Rs 51,00,000, rent Rs 12,00,000 and insurance the full Rs 4,00,000. Add those up and the business paid out Rs 1,93,00,000 against Rs 1,92,00,000 received. Cash opened at Rs 8,00,000 and closed at Rs 7,00,000.

The two columns share a great deal. Rent was charged and paid in the same year, so it appears at Rs 12,00,000 on both sides. The paper suppliers took exactly the Rs 1,26,00,000 that shows as cost of goods sold, by coincidence of the year's buying and selling. Everything else differs, and every one of those differences is either a timing gap or an entry that never touches money at all. The differences are the list that has to be written out, and the table below writes it out in full.

Where exactly does the difference between the two figures sit?

A profit figure and a cash figure are never joined by a mystery. The two figures are joined by a list, and the list closes to the rupee or something is wrong. The list starts at Rs 38,00,000 of profit and makes eight adjustments. Each adjustment is a thing standing somewhere inside Anjani Stationers that could be walked over to and pointed at. Two of them are charges that reduced profit without moving money. One is money billed to the schools and not collected. One is paper bought and still standing in the store. Two are things the business has had the benefit of and not yet paid for: the extra credit the paper suppliers allowed, recorded as a rise in payablesMoney the business has been billed for by its own suppliers and has not yet paid. Taking longer to pay leaves more money in the bank for now and settles nothing., and the March salaries. One is a payment made for months that have not arrived yet.

Eight lines carry Rs 38,00,000 of profit down to minus Rs 1,00,000 of cash, and one of the eight, the Rs 48,00,000 rise in what the schools still owe, is larger than the other seven put together. The size of that one line is the fact to carry away. The two non-cash charges pull upward by Rs 8,00,000 between them. The unpaid March salaries and the extra credit taken from the paper suppliers pull upward by Rs 9,00,000. Against that, the money tied up in unpaid school bills, in stacked paper and in insurance bought ahead pulls downward by Rs 56,00,000. Drawn as a fall, the shape is unmistakable: three small steps up, one enormous step down, and a series of small corrections that never recover the ground.

If the profit is real, where is the money actually sitting?

Anjani Kulkarni put exactly that question to Meera Rao on 2 April, and the question has a physical answer. The gap between Rs 38,00,000 of profit and minus Rs 1,00,000 of cash is Rs 39,00,000, and not one rupee of it has disappeared. A walk through the business on the evening of 31 March finds almost all of it within reach. In the filing tray there are unpaid school bills totalling Rs 78,00,000, of which the Sunrise Public School group's overdue Rs 6,00,000 is the worrying part. In the store there is Rs 22,00,000 of paper and finished notebooks stacked against the wall, bought with money and not yet sold. In a folder there is an insurance policy with Rs 2,00,000 of cover already paid for and not yet used. And in the bank there is Rs 7,00,000.

The money is not missing; it has changed shape, and every shape it has taken is something the business chose to do. Delivering notebooks to a school that pays in ninety days is a choice. Keeping enough paper in the store to print through the admission rush is a choice. Paying a year of insurance in one go, usually because paying monthly costs more, is a choice. None of them is a mistake, and all of them together are why the bank account does not look like the profit statement.

There is a second place to look, and almost nobody thinks of it first. The profit did not vanish from the books either. Opening equityWhat is left when everything the business is recorded as having is added up and everything it has to repay is taken away. It is the owner's share of the business, not a pile of money. was Rs 74,00,000 and closing equity is Rs 1,12,00,000, exactly Rs 38,00,000 higher, so the profit is sitting right there in what the owner has built up in the business. Only the form of the assets changed. The business is worth Rs 38,00,000 more than it was, and Rs 7,00,000 of its Rs 1,33,00,000 of assets is money. Being worth more and having more money are two different things, and the distance between them is most of what separates a strong balance sheet from a payable bill.

What happens to the two figures when the schools pay more slowly?

Now change one thing and watch. Hold the trading exactly where it was, so the same notebooks are printed and delivered at the same prices to the same schools, and vary only how much the schools still owe on 31 March. If they clear their dues faster, the closing figure is smaller; if they drag, it is larger. Everything else in the year stays put.

Profit is decided by the trading, so the profit line does not move at all when collection speeds up or slows down; only the cash line moves. A profit line that stays flat while the cash line moves is the single most counter-intuitive fact about the two bases. Anjani Stationers would report Rs 38,00,000 of profit whether the schools owed Rs 30,00,000 or Rs 1,10,00,000 at the year end. Only the cash movement changes, from Rs 47,00,000 into the bank at one end of the range to Rs 33,00,000 out of it at the other. The two lines below start together on the left, where collection is fast, and separate steadily as it slows.

Which of the two figures is the right one?

Everybody asks which figure is the right one, and it is the wrong question, in the specific sense that it has no answer. Ask instead what each figure is for. The accrual figure answers whether the trading worked: did the notebooks sell for more than they cost to make, once every cost the year actually used has been counted. The cash figure answers whether the business can pay what falls due: is there money in the account on the morning the paper supplier's cheque is presented.

Each basis answers one question well and the other question not at all, so a reader who takes one number and discards the other has thrown away half of what they needed. A business with a good accrual figure and a bad cash figure is usually growing faster than its collection can carry. Growing faster than collection can carry is uncomfortable but often fixable. A business with a bad accrual figure and a good cash figure is usually selling stock it already had, or collecting old dues. Living off old stock and old dues feels comfortable and is often the more dangerous of the two. One number cannot tell the two situations apart.

How does a lender or an analyst read the two figures together?

Watch what an experienced reader actually does with a set of accounts. The order is a sequence, not a preference. A lender assessing whether Anjani Stationers can meet a payment next month starts with the money, not the profit. Loans are repaid in rupees that clear, so the first questions are what is in the account, what is coming in over the next sixty days, and what has already been promised to somebody else. Only then does the lender turn to the accrual figures to ask a different question: is this a business worth being exposed to at all, or is the Rs 38,00,000 the last good year of a trade that is quietly shrinking.

The habit worth building is to read the two figures as a pair and to treat any large or widening space between them as a question, never as an error. A profit of Rs 38,00,000 against a cash movement of minus Rs 1,00,000 is not a red flag by itself. Growth is paid for in advance and collected afterwards, so in a year when a business grew its billing hard that pattern is close to normal. The pattern becomes a flag when it repeats year after year without the collection ever catching up. A business whose customers are slowly stopping paying looks exactly like that: its books still record every delivery as a sale and the money never arrives.

An investor asks the third version of the same question. Over several years, does the money eventually arrive? Profit that keeps being reported while the space below it keeps widening is profit that has never turned into anything spendable, and a reader who tracks only the top figure will be the last person in the room to notice. A household runs the identical test without any of the vocabulary: a salary slip says what was earned this month, and the bank app says what is left after the school fee went out on the first, and a person who reads only the salary slip is exactly as misled as an investor who reads only the profit line.

What does profitable and out of cash actually look like from the inside?

A profitable business out of cash does not look like a failing business, and that is precisely what makes the position dangerous. The printing unit is busy. The order book is full. The staff are paid, a little late in March, and nobody complains. The books show the best year the business has ever had. Everything an owner would normally use to check that things are going well is telling the truth and telling it in the affirmative. Meanwhile the account has Rs 7,00,000 in it, the paper supplier is owed Rs 18,00,000, and the March salaries of Rs 3,00,000 have not gone out.

A business in this position is not failing at trade; it is failing at timing, and timing is what stops printing presses. The sequence is always the same. Money is committed against a profit figure. The money is not there when the commitment falls due. Then something that was working breaks. Usually it is supply: the supplier is the one creditor who can stop the business inside a week. Then the busiest month arrives with no paper in the store, and a business that was genuinely making money loses the season that would have collected it.

Anjani Stationers Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.