What Is Accrual Accounting?
Accrual accounting recognizes economic activity when it happens rather than when cash moves. Revenue is booked when a product is delivered or a service is performed, and expenses are booked when they are incurred, even if payment comes earlier or later.
This contrasts with cash accounting, which only records transactions when money is received or paid. Public companies must use accrual accounting under GAAP and IFRS because it gives a truer picture of performance in each period.
How It Works
The system rests on the matching principle: expenses should be recorded in the same period as the revenue they help produce. Timing differences between economic activity and cash create balance sheet accounts like accounts receivable (revenue earned, cash not yet collected), accounts payable (expense incurred, cash not yet paid), and deferred revenue (cash collected, revenue not yet earned).
Because reported net income under accrual accounting is not the same as cash generated, the cash flow statement exists to reconcile the two, starting with net income and adjusting for non-cash items and working capital changes.
Example
Suppose a consulting firm completes a $100,000 project in December but the client pays in February. Under accrual accounting, the firm records $100,000 of revenue in December along with a $100,000 account receivable, and simply converts the receivable to cash in February with no new revenue. Under cash accounting, the revenue would not appear until February, distorting both periods.
Why It Matters
Accrual accounting is why net income and cash flow can diverge sharply, and understanding that gap is at the heart of financial analysis. A company can report strong profits while burning cash, or modest profits while gushing cash, depending on working capital and non-cash charges.
Nearly every accounting question in investment banking interviews, from walking through $10 of depreciation to explaining deferred revenue, is really a test of whether you understand accrual concepts.
