As we’ve seen so far, if we only think in terms of cash, accounting would be really simple. In fact, I think the concept of accounting itself might not even exist. In this session, we will look at four cases to examine what problems exist with measuring company performance based solely on cash.

Here is the first case. Imagine a car company sells a car for $50,000 in December. However, the customer didn’t pay in cash, but used a card for the payment. Since it was paid by card, the car company will settle the payment in January of the following year. In this case, should the company’s December revenue be $50,000, or $0? If you were to seriously prepare the company’s performance report for December, would you want to include the $50,000 in December’s results or January’s results? Most people would think it’s correct to include it in December’s performance, even though the cash isn’t received until January.

Let’s look at the second case. Imagine I run a company and need to pay the employees' salaries. But as most of you who have worked before know, companies don't pay salaries every day, right? In fact, it’s quite common for salaries earned in January to be paid in mid-February. Although it may feel unfair to employees, it’s actually very beneficial for the company. In this case, should the employees' $3 million in wages be recorded in January, when the work was done, or in February, when the actual cash payment occurs? This is a rather tricky question to consider.

The third case might be a bit harder to answer definitively. For example, let’s imagine that I bought clothes from a factory in China and am selling them in a small shop in front of my house. In January, I purchased $1 million worth of clothes, but I expect to actually sell them after February. In this case, should the $1 million spent on the clothes be considered an expense in January, or should it be accounted for as an expense after the sales are made in February? This might be a bit trickier than the previous two cases. First, to give you the answer, the $1 million expense will be recognized in the month when the clothes are actually sold. We will go into more detail on this later.

Next, let's go back to the car company story. If you look at the company's performance over the past three years, you can see that it’s doing really well. Revenue has been doubling each year, and costs are increasing accordingly, so as a result, the company’s profit is growing significantly—70, 140, and 300, respectively. However, in 2024, the company decided to build a new factory, investing 500 to sell even more cars in the future. If we were to write the performance report based on cash, the result for 2024 would show a loss, with an additional expense of 500. As a manager of this company, you would feel frustrated with such a report. You made a large investment with a long-term perspective, but if this were immediately reflected in the performance report, the management would naturally become reluctant to invest.

So, what should we do to solve this? The solution is to divide the 500 expense by 10, as it is for a factory that will be used over the next 10 years, and then expense 50 each year. This way, we can reasonably measure the company's costs. The company's performance report would look normal again.

Like this, accounting strives to measure a company's performance rationally and accurately. In this process, situations arise where the timing of cash inflows and outflows differs. The method of thinking based strictly on cash flow, like in the cash flow statement, is called Cash Basis, and the effort to measure performance rationally, as we saw earlier, is called Accrual Basis. From now on, it is very important to think from the perspective of Accrual Basis in accounting. In fact, we will be looking at, analyzing, and comparing many financial statements that are prepared from the Accrual Basis perspective.