Glossary
Accrual accounting
Recording revenue when it is earned and expenses when they are incurred, not when cash actually changes hands.
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Accrual accounting is the method of recording revenue in the period it is earned and expenses in the period they are incurred, regardless of when cash is received or paid. US public companies must use it, because it is required under GAAP, so every income statement you read on a 10-K or 10-Q is built on accruals.
How it works
Two ideas drive the method. Revenue recognition says a sale counts once the company has delivered what it promised. The matching principle says the costs of earning that revenue belong in the same period. The timing differences show up on the balance sheet as accounts such as receivables, payables, prepaid expenses, deferred revenue and accrued liabilities.
Expenses work the same way. A factory machine bought for $500,000 and expected to last ten years is not expensed all at once; it is depreciated, about $50,000 a year on a straight-line basis.
Accruals versus cash
Accrual accounting gives a truer picture of a company's economic performance in a period, but it relies on estimates and judgment, which leaves room for error or manipulation. That is why analysts read net income alongside the cash flow statement. A company whose profits consistently exceed its operating cash flow, by a widening margin, is relying heavily on accruals, and that deserves a closer look.
Small businesses and individuals often use the simpler cash basis instead.