Accrual Accounting
Recognising revenue when earned and expenses when incurred, regardless of when cash moves. The foundation of GAAP/IFRS reporting, and the reason net income and cash flow diverge.
Behind the balance sheet · 2 of 17Next: Working Capital
Why Accrual Accounting matters in interviews
Every other question about the three statements is a question about this one. Accrual accounting is the rule that revenue is recorded when it is earned and a cost when it is incurred, whichever way the cash moved, and it is the reason a profitable company can run out of money and a loss-making one can be flush. An interviewer who asks why net income and cash flow differ, why working capital absorbs cash, or what deferred revenue is, is asking whether you understand this rule and can follow one transaction through the statements under it.
How it works in practice
Revenue is recognised when the performance obligation is satisfied (IFRS 15, ASC 606): when the goods are delivered or the service is rendered, not when the invoice is paid. A sale on 60-day terms is revenue today and a receivable until the cash arrives. A subscription collected for the year ahead is cash today and a liability, deferred revenue, until each month is delivered.
Costs follow the revenue they help earn, which is the matching principle. Wages are a cost in the month worked, whether paid on the 25th or the 5th of the next month; the unpaid part is an accrual, a liability. A machine bought for five years of use is a cost over five years, as depreciation, not a cost in the month the cash left. Both are the same rule from the other side.
The cash flow statement is the reconciliation. It starts from net income, which is the accrual view, and works back to the cash that actually moved: adding back charges that took no cash (depreciation, share-based payment, deferred tax), and adjusting for the timing differences the balance sheet holds (the change in receivables, inventory, payables and deferred revenue). Read that way, the statement is a list of every place the accrual rule and the bank balance disagreed this period.
The alternative, cash accounting, exists and is used by small businesses and for some tax purposes. It records a sale when paid and a cost when paid. It is simpler and it is also nearly useless for reading a business, because a year in which a company collected last year’s sales and delayed paying this year’s suppliers looks like its best year ever.
What candidates get wrong
- Saying revenue is recognised "when the cash comes in". It is recognised when it is earned. The cash timing is what the balance sheet carries as a receivable or as deferred revenue.
- Treating depreciation as a cash cost, or the depreciation add-back as free money. The cash left when the asset was bought; the charge is the accrual rule spreading it over the years the asset earns.
- Reading a rise in net income as a rise in cash. The two can move in opposite directions for several quarters, and the change in working capital is usually why.
- Forgetting that accruals are estimates. Useful lives, bad-debt provisions, warranty reserves and the stage of completion on a long contract are all judgements, and the note says which ones management made.
Accrual Accounting: frequently asked questions
What is accrual accounting?
Recording revenue when it is earned and costs when they are incurred, regardless of when cash changes hands. It is the basis of IFRS and US GAAP, and it is why the income statement and the cash flow statement tell different stories about the same period: the first follows the economics, the second follows the money.
Why do net income and cash flow differ?
Because net income is an accrual figure and cash flow is not. Sales made but not yet collected, costs charged but not yet paid, cash collected for work not yet done, and the cost of assets spread over their lives all sit between the two. The cash flow statement lists each of those differences and adds them back to net income to arrive at the cash that moved.
What is the matching principle?
The half of accrual accounting that deals with costs: a cost is recognised in the same period as the revenue it helped earn. It is why a machine is depreciated over its useful life rather than expensed when bought, why inventory becomes a cost only when it is sold, and why December’s wages paid in January are December’s cost.
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