A method of accounting that recognizes expenses when incurred and revenue when earned rather than when payment is made or received. Thus, it is the act of sending the goods or receiving an inventory item that is important in determining when transactions are posted on financial statements. For example, using accrual accounting, sales are recorded as revenue when goods are shipped even though payment is not expected for days, weeks, or months. Most firms use the accrual basis of accounting in recording transactions. Compare cash basis accounting .
Case Study Recording revenues that are used to calculate earnings before actually receiving those revenues can potentially misrepresent a firm's financial results and lead to financial difficulties down the road. For example, a company that ships substantial amounts of goods on credit may produce outstanding earnings in the current accounting period, but if customers who receive the goods fail to pay for the merchandise, future earnings are likely to suffer. Firms build an estimate for doubtful payments into the revenues and earnings they report, but the estimates may be understated and make earnings look better than they actually are. More than a few companies have been known to ship unusually large amounts of merchandise near the end of a fiscal year in order to make the year's sales and earnings appear favorable even though the extra sales produce an unrealistic picture of the firm's operations. In one instance,
a large toy company was offering special incentives to customers that loaded up with the firm's merchandise just prior to the end of the year. This, of course, is perfectly legal. However, the company offering the incentives was accused of overstating its earnings by not properly accounting for the expense of the incentives being offered. A firm that aggressively pursues end-of-year sales may end up selling to some financially weak customers who fail to pay for the merchandise. Unfortunately, it is difficult for stockholders to know the extent to which a firm's actions serve to puff up the financial statements rather than produce real results.
What Does Accrual Accounting Mean?
An accounting method that measures the performance and status of a company regardless of when cash transactions occur; financial transactions and events are recognized by matching revenues to expenses (the matching principle) at the time when the transaction occurs rather than when payment actually is made (or received). This allows current cash inflows and outflows to be combined with expected future cash inflows and outflows to provide a more accurate picture of a company's current financial condition. Accrual accounting is the standard accounting practice for most big companies; however, its relative complexity makes it more expensive to implement for small companies. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.
Investopedia explains Accrual Accounting