[MUSIC] At this point, you should have very clear in mind that profitability and liquidity are not the same thing. That is, the profit of the firm is not the same as the change in cash experienced by the firm. The reason for this is that profit equals revenues minus expenses, whereas change in cash is cash inflows minus cash outflows and revenues is not the same as cash receipts necessarily and expenses is not the same as cash payments either. Remember the case, for example, of credit sales. When we make a sale on credit, we are delivering the product. So we are recognizing the sale, but we are not collecting the cash yet. We just have the promise of the customer to pay us, but still we recognize the revenue. In the case of expenses, you have the example of depreciation where you recognize an expense, the loss and value of an asset, but you don't recognize any cash outflow. I show you the cash outflow took place at the moment we purchased that asset in the past. So, what is the reason behind this difference between profit and changing cash? Well, the reason is called accrual accounting. Accrual account is the accounting method by which we're recognize economic events when they happen no matter whether there is cash associated with that transaction or not. For example, the recognition of revenues normally is recorded at the moment we deliver the product. No matter whether we collect the cash or not at that same moment. If it is a credit sale, we will recognize the sale and we are to collect the cash later on. Note that if instead of accrual accounting, we were using cash accounting, then we wouldn't record this revenue until the moment we collect the cash. Because under cash accounting, the only thing that matters is cash. Cash inflows and cash outflows. So anything else that happens in the company is not going to be recorded, if it doesn't affect cash. In real life, companies use accrual accounting. So, they record economic events when they happen no matter whether cash moves or not. We have already seen a few examples of these at the campus bookstore. Credit sales, as we mentioned. The prepayment of the rent, where we make the payment first and then we recognize the expense later on. Purchases of inventory on credit and so on, and so forth. The question is why using a crew like accounting instead of cash accounting? Obviously, cash accounting is much easier, so there is no doubt about when to recognize things or not. Let's see an example through the campus bookstore in order to illustrate why accrual accounting is so important. If the campus bookstore was using cash accounting, the only information that the campus bookstore would provide would be the cash T account. At the most, it would provide the cash flow statements by just organizing all these payments and receipts of cash. All the other things that do not affect cash are not relevant for cash accounting. So bearing that in mind, what would be the shortcomings of this kind of accounting? Remember that this is same question I posed to you in the beginning of this course. So, what are the limitations of cash accounting? Well, first of all, you would be missing information about assets. Assets that you have purchased on credit such as some of the inventory, for example. It's true that you didn't pay yet for the inventory, but you own that inventory and you have it. And it has a future value and you can sell it whenever you want, it's yours therefore that's relevant information that you are missing. Next, you're missing some of your obligations. The payments that you have to make to your suppliers, for example. So, you wouldn't have information about accounts payable. The only information you would have is the amounts that you have all ready paid. Third, you will be missing information about sales and expenses on credit. Things that you don't pay in cash right at that moment. And yet, you have accruing those revenues and expenses. In summary, we are missing any economic event that doesn't effect the cash account. We are actually missing as well all the previous assets and liabilities that we had recognized in the past in previous periods, because the cash account is only for this particular year. In addition, if we were using cash accounting, the profit for the year of that company would be sort of cash profit, so the change in the cash account for the year. In this case, the company has increased cash by 1,000. Can we say that shareholders are richer by 1,000 Euros? Is this cash profit a good measure of the performance of the company? Given that initial investment in this company was 50,000 Euros, can we see that the return on equities 1,000, which is this cash profit divided by 50,000, so 2% return on equity? In the next video, we're going to try to respond to this question. Is cash profit a good measure of performance? Or rather, we'd better have some sort of accrual measure of performance. [MUSIC]
