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Accrual basis accounting

Accrual basis accounting is an accounting method where income is reported when earned and expenses are reported when incurred, regardless of when the cash flows actually occur.

Expanded Definition

Financial statements of all publicly traded companies use accrual basis accounting, as dictated by Generally Accepted Accounting Principles (or "GAAP"). That is, revenue and expenses are recognized in the time periods in which they are earned or incurred, even if the cash payments have not been received or paid out yet.

This is in contrast to cash-basis accounting, which reports revenue when it is actually received and expenses when they're actually paid. You and I typically use cash accounting, deducting the payment for the electric bill (for instance) on the day we pay it, rather than accruing an amount over the course of the month depending on our daily electricity use.

Accrual basis accounting is used because it gives a more accurate representation of a company's financial status because it shows both what has happened and what it is owed (and what it owes). When you look at your checking account balance at the end of the month, that is not representative of your financial status because you owe, among other things, that electric bill due next week and you'll be paid on the 5th. A company's financial statements reflects such items.

Here's an example: If 2,000 widgets are sold to a customer in the last month of the first quarter and the customer is allowed 45 days to pay for them, accrual accounting puts the revenue into the first quarter, even though the cash won't likely be received until the first month of the second quarter when the 45 days are up. That revenue has been earned in the first quarter, so it gets counted in the first quarter, not in the second quarter when the company gets paid. Similarly, expenses related to that sale (for instance salaries of the employees making the sale) are recognized, even though the cash payment may not have been made yet (e.g. if the next payday is the 5th of the following month).

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