Accrual accounting

The convention under which revenue is recorded when it is earned and costs when they are incurred, regardless of when money actually changed hands.

Example

A sale made in December and paid for in March belongs to December's income statement and to March's cash flow statement.

Important

This single convention is the source of almost every misreading of accounts. It makes the income statement a better description of performance and a worse description of cash.

Related terms

  • Income statement — A report of what a business earned and what it spent over a period of time, arranged in layers from revenue at the top down to net profit at the bottom.
  • Cash flow statement — The statement explaining how the bank balance moved over a period, split into cash from operating the business, cash spent on or received from long-term assets, and cash raised from or returned to lenders and owners.
  • Working capital — The money tied up in ordinary trading. The operating version - receivables plus inventory minus payables - excludes cash and borrowings, and is the one that behaves like a use of money.

Lessons that explain it

  • Not every number called revenue is the same kind of money — Financial diligence starts by separating recurring revenue from one-off fees, bookings from recognised revenue, and invoiced amounts from cash collected. (11 min)
  • Messy books are common; hidden liabilities are the real risk — Early companies often have informal accounting. Diligence separates harmless untidiness from problems that matter: unpaid taxes, related-party transactions, commingled spending and unrecorded obligations. (10 min)
  • The income statement: what it claims was earned — The income statement is a claim about performance over a period, assembled under rules that deliberately ignore when the cash moved. Read properly it is the most useful statement; read literally it is the most misleading. (12 min)
  • When the cash and the profit disagree, believe the cash — Most accounting problems show up as a widening gap between reported profit and cash collected. A few ratios, tracked over time, catch the common ones. (12 min)

All 578 terms in the Investing glossary