Accrual accounting

Accrual accounting is the convention that makes the income statement useful and, at the same time, makes it possible for a profitable company to run out of money. Revenue is recognised when the company has done the work, not when the customer pays. Costs are recognised in the period they helped generate that revenue, not when the supplier is settled.

The alternative, cash accounting, records everything when cash moves. That is simpler and impossible to manipulate, but it describes a business badly: a company that signs a large contract in December and gets paid in March looks dead in December and spectacular in March, when in reality nothing changed between the two.

Almost every consequence in financial statement analysis flows from this one choice. Because profit and cash are recognised at different moments, the gap between them has to live somewhere, and that somewhere is working capital on the balance sheet. Revenue earned but not yet collected becomes a receivable. Cash collected before the work is done becomes deferred revenue. Costs incurred but not yet paid become payables.

This is also why the cash flow statement exists. If accounting recognised everything on a cash basis, the cash flow statement would just be the income statement again. The whole document is a reconciliation between an accrual number at the top and a cash number at the bottom.