Accrual accounting is the foundation of the GAAP financial accounting scheme. Therefore, a keen understanding of accrual accounting concepts is crucial for financial statement analysis. GAAP is underpinned by two core principles: the revenue recognition principle and the matching principle, the former guiding the amount and timing of revenue recognition and the latter guiding the amount and timing of expense recognition. Both principles suggest that revenues/expenses should be recognized when they are earned/incurred rather than when the associated cash is received/paid. This means that revenues and/or expenses can also be recognized in the same time period as the cash flow, but they do not need to be. Following the principles above results in four possible scenarios in which revenue and expense recognition can be in a different time period than cash flow. The textbook describes these four types of accounting “adjustments” on page 2-27.
This week, let’s discuss the importance of accrual accounting for financial statement analysis. What makes accrual accounting important in an analysis setting anyway? Isn’t cash king? Why do decision makers need accrual-based accounting information? What do accruals have to do with how the financial statements interact with each other?