Accrual accounting explained

People generally think of accounting in terms of cash flows.  Money comes in and money goes out.  However, this is not how accountants measure revenues, expenses or net income.  They use a system called accrual accounting.

Accrual accounting records revenues when they are earned and expenses when they are incurred.

Revenues are earned when the seller provides the service, or delivers whatever products that it is supposed to provide in exchange for the revenues.  For example, a Department Store earns revenue from a sweater when it actually gives the sweater to the customer.  It does not matter if the customer pays for the sweater in advance (lay-away) or a month later (credit card sales).

Expenses are recorded when incurred.  As I’ve written before, expenses provide some benefit to the company – otherwise the company would not bother to have any expenses.  Usually expenses will cause something to happen that will increase revenues or profits.  Most expenses, therefore, are recorded when the company actually gets the benefit from them.  For example, your utility bill expense is recorded when you use the heat and lights, and not necessarily when you actually pay for the expense.

Some expenses are recorded as soon as a loss occurs.  For example, if your uninsured building was destroyed by a flood, you would need to record the loss immediately.

As I’ve stated before, net income is just the difference between revenues and expenses.

Not that you should ignore cash flow, but net income provides a more accurate measure of your performance than cash flow.  In fact, a company with negative cash flow can be profitable, and a company with great cash flow can be unprofitable.  For example, you might have high sales which you will not collect until the future – this would cause robust profitability, but poor cash flow.  Alternatively, liquidating your inventory will improve cash flow, but hurt future sales and profitability.

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