Accrual vs Cash Accounting

If you ran a lemonade stand and someone paid you $5 today for lemonade you're delivering next week, did you earn that $5 today or next week? Cash accounting says today — you record income the moment money hits your hand. Accrual accounting says next week — you record income when you've actually delivered the lemonade, regardless of when the cash arrived. That single choice about timing is the difference between the two systems, and it changes what a company's reported profit means.

The two systems

Under cash accounting, revenue is recorded when cash is received and expenses when cash is paid out. It's simple and intuitive — your checking account balance basically is your income statement — which is why small businesses and sole proprietors are often allowed to use it.

Under accrual accounting, revenue is recorded when it's earned (goods delivered, service performed) and expenses when they're incurred (the cost is owed), regardless of when cash actually changes hands. US GAAP and IFRS require accrual accounting for any company of meaningful size, because it matches revenue to the costs that generated it in the same period, giving a truer picture of economic performance than a cash ledger that can be timed almost arbitrarily.

A worked example

A consulting firm signs a $120,000 contract on 1 December to deliver work over the next twelve months, and the client pays the full $120,000 upfront. Under cash accounting, the firm records $120,000 of December revenue — the entire year's income shows up in one month. Under accrual accounting, the firm recognizes only $120{,}000 / 12 = 10{,}000$ of revenue in December, i.e. $10,000, the portion actually earned that month, and carries the remaining $110,000 on the balance sheet as deferred revenue — a liability, because the firm still owes eleven months of undelivered work.

Now suppose the firm also pays a $24,000 annual insurance premium in December, covering the next twelve months. Cash accounting expenses the full $24,000 in December. Accrual accounting expenses $24{,}000/12 = 2{,}000$, i.e. $2,000, in December and carries $22,000 as a prepaid expense, an asset, released to the income statement $2,000 at a time over the year.

Compare the two views of December alone: cash accounting shows $120{,}000 - 24{,}000 = 96{,}000$ ($96,000) of net cash profit; accrual accounting shows $10{,}000 - 2{,}000 = 8{,}000$ ($8,000) of net income. Same company, same month, a twelvefold difference in reported profit purely from timing convention.

Why this matters for anyone reading statements

Accrual earnings can diverge sharply from cash in the business for a stretch — a company can report growing profit while burning cash if it's aggressively recognizing revenue on invoices customers haven't paid yet, or conversely report a loss while cash builds because of large non-cash charges like depreciation. That gap is exactly why the cash flow statement exists as a required third statement: it takes accrual net income and reverses out the non-cash and timing effects to show what actually happened to cash.