Accrual is a fundamental accounting principle that is pivotal for understanding the financial health of businesses. It is the recognition of revenue and expenses that have been incurred but not yet received or paid. This principle is central to the accrual basis of accounting, which is the standard approach for most companies, especially those publicly traded.
What is Accrual?
Accrual is the process of recognizing economic events regardless of when the cash transaction occurs. This is in contrast to cash accounting, where transactions are only recorded when cash changes hands. Accrual accounting provides a more accurate picture of a company’s financial condition by aligning income and related expenses in the same accounting period.
For example, consider a software company that signs a $12,000 contract for a one-year subscription. Under the accrual basis, the company would recognize $1,000 of revenue each month, even if the customer pays the entire amount upfront. This method ensures that the revenue matches the period in which the service is provided.
Accrual in Practice: Case Studies
- Deferred Revenue: A magazine publisher receives a $120 subscription fee for a yearly subscription. Under accrual accounting, the $120 is initially recorded as a liability called “Deferred Revenue.” Each month, $10 is moved from deferred revenue to earned revenue, aligning with the delivery of each issue.
- Accrued Expenses: A corporation may have employees who have worked in December, but their salaries won’t be paid until January. Under the accrual method, the salaries are recorded as an expense in December, even though the cash will be paid later.
Accrual Explained: Implications for Financial Analysis
Accrual accounting has significant implications for financial analysis and should be considered when evaluating a company’s profitability and liquidity. For instance, a company with high accruals but low cash inflows may struggle to meet its short-term obligations, despite appearing profitable on paper.
Investors often scrutinize the quality of a company’s accruals. Academic research, such as the work by Professor Richard Sloan, has shown that firms with lower accruals tend to have higher future stock returns. This is because low accruals often indicate that a greater portion of a company’s earnings are backed by actual cash flows.
Accrual is a cornerstone of modern accounting that provides a comprehensive view of a company’s financial situation. It allows for the matching of revenue and expenses, thereby offering a more nuanced understanding of profitability over an accounting period. However, it’s crucial to note that while accrual gives a more accurate picture of economic reality, it also requires more complex accounting procedures and a deeper understanding of financial statements. Therefore, when asking “What is accrual?”, one must consider not just its definition but also its practical implications for financial reporting and analysis.