Accrual accounting is a system of recognizing inflows and outflows. My goal in writing about it does not include a conversation about all the technical aspects that are well beyond the scope of “blog posts.” Rather, I want to provide a decent “feel” for the terminology so it can become more useful when you are analyzing the financials of companies, especially the Income Statement.

A system that is easier to understand than accrual accounting is cash accounting. Following a cash basis, recognition of an inflow occurs when cash comes in and an outflow is recorded when cash goes out.

With accrual accounting, we don’t define inflows and outflows according to when cash comes in or goes out. An inflow is redefined, if you will permit that expression, by generally accepted accounting practice, as a “revenue” and an outflow as an “expense.” In this post today, I’ll talk about the recording of a revenue.

What does the term revenue mean? Revenue represents an enhancement to the company’s equity that results from the providing of goods or services to customers.

When is revenue “recognized” under accrual accounting? Well, first, recognition is a term which refers to “recording in the books.” So, recognition happens when the company makes an accounting entry to “recognize” the item (in this conversation, the item is a revenue). If revenues are not recognized based on the timing of cash receipts from selling goods/services, then what is the determinant of when they are recorded?

Under accrual accounting principles, revenues are recognized according to the “revenue recognition” principle. This principle states that revenue should be recorded when two things have occurred (note, both must have occurred). The money must be “earned” and “realizable.” A simple example of this principle being applied is when you see a company recording “sales revenue” upon shipping goods to a customer even though the customer has not paid for the goods yet. The company will record the sales revenue and, at the same time, recognize an asset called “accounts receivable” in place of the cash yet to be collected. The “sales revenue” is “recognized” because the goods have left the seller’s hands (been earned) and there is the expectation by the seller of collecting on the goods in the near future (realizable).

Regardless of the source of revenue (companies provide very different products and services), the monies recognized must be both earned and realizable. In some cases, the timing of revenue recognition is clear as a bell. That is, “when” money is both “earned” and “realizable,” is very evident. In some cases, there’s a lot of judgment involved as in the case of a company that constructs bridges by contract and bills out the contract as it is incrementally fulfilled. “Realizable” involves judgment. Companies know some customers may never pay. That is, some portion of sales will probably never be received. Therefore, companies must estimate some percentage of bad debts against the revenues recognized to avoid misstatement of revenue.

The important takeaway for investors is that accrual accounting involves judgment in the timing of an inflow (revenue) recognition that is not needed when the inflow is simply defined by the timing of cash coming in. This judgment is being exercised by the company management responsible to shareholders for the reporting. As a stockholder, I need to always be aware that the sales numbers, for example, include this type judgment and therefore be careful of companies that might show a pattern of liberality in making such judgments.

Why do we need to have a system like accrual accounting that records events that may not be precise at the time of recognition and could conceivably be managed for “timing” of recognition (by corporate management)? The answer is simply that shareholders need to be able to predict future cash flows. A cash basis of recognition would not give us that ability. For example, consider a retail company that operates on a calendar fiscal year and it has made $5M in sales all year until December 31. On December 31, the company sells $20M, all on account. If the company is recording events on a cash basis only, the $20M  in sales will not be recognized for that year because the money is yet to be collected by the close of the year. However, under accrual accounting, the sales will be recognized in the same year as the sale. Recognizing the $20M will enable shareholders who read that year’s Income Statement to predict the future cash windfall arising from the big sale.

See you next time.