Accrual accounting and cash accounting

Accrual accounting records a transaction when it is earned or incurred, not when cash moves. A company books revenue when it delivers a product or service, even if the customer pays months later, and books an expense when it uses something up, even if the bill is settled afterward. Cash accounting is the simpler alternative: a sale counts when the cash arrives and an expense counts when the cash leaves.

Public companies report under accrual accounting, because cash accounting would make revenue and expenses swing with payment timing instead of with the underlying business activity. Both GAAP and IFRS are built on the accrual basis, which is why items such as accounts receivable, deferred revenue and depreciation exist on the financial statements at all. Each one is a timing difference between when something is recorded and when cash changes hands.

The tradeoff is that accrual figures depend on estimates: how long equipment will last, how much of what customers owe will be collected, when a long contract has been earned. That is why net income and the cash a business generates in the same year can differ widely. Comparing net income with operating cash flow and free cash flow over several years shows whether reported profit is turning into cash, and a persistent shortfall is a reason to look more closely at the estimates behind the numbers.