Tell accrual accounting apart from cash accounting
The idea
Accrual accounting recognises revenue when it is earned and expenses when they are incurred, regardless of when cash moves, which is what allows a period's statements to describe the period's economic activity rather than its banking. The cost is that recognition depends on judgement, and judgement can be exercised to flatter. Cash flow is far harder to manipulate but tells a lagged and lumpy story. The gap between net income and operating cash flow — accruals — is therefore one of the most informative figures in a set of accounts, and a persistently large positive gap is a recognised warning sign.
A practice question
Under accrual accounting, when is revenue recognised?
- When cash is receivedWhy not: That is the cash basis, which accrual accounting exists to replace. A credit sale is revenue on delivery and a receivable until paid.
- When it is earned, regardless of when cash is received — correct
- At the end of the reporting periodWhy not: Recognition follows the economic event, whenever in the period it happens. Period end is when the books are closed, not when revenue is earned.
Matching recognition to economic activity rather than to cash timing is the whole purpose of accrual accounting.
A harder one
A company delays paying suppliers by three weeks near the year end. What happens?
- Operating cash flow improves and the company is no better off — correct
- Net income risesWhy not: The expense was recognised when incurred, so paying later changes nothing on the income statement.
- Both net income and cash flow riseWhy not: Only cash flow moves. That asymmetry is the point — it flatters one statement while the other correctly shows nothing has improved.
Accrual accounting is unaffected because the expense was already recognised. The cash flow statement flatters a timing decision, which is one reason cash alone is not a better measure.
The hardest tier
Why is accrual earnings not simply inferior to cash flow, given that cash is harder to manipulate?
- Because cash flow is unauditedWhy not: It is audited alongside the other statements.
- Because cash timing is a poor descriptor — correct
- Because cash flow excludes interestWhy not: It includes interest — under US GAAP within operating, and under IFRS wherever the company's policy places it.
A period's cash reflects decisions and events belonging to other periods. A company that stretches payables or delays capital spending reports better cash and is not better off, which is the reason accrual accounting exists.
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