The Short Version
Most public companies use accrual accounting, which records revenue when it's earned and expenses when they're incurred — regardless of when cash actually changes hands. Cash accounting, by contrast, only records transactions when cash is actually received or paid. Accrual accounting gives a more complete picture of ongoing business activity, but it's also why 'profit' and 'cash' can tell very different stories, which is exactly why the Cash Flow Statement exists as its own report.
Explain It Like I'm 10
Imagine you mow a neighbor's lawn on Saturday, and they say 'I'll pay you next Friday.' Under 'cash accounting,' you wouldn't count that $20 as earned until Friday when you actually get paid. Under 'accrual accounting' (what real companies use), you count the $20 as earned on Saturday — the moment you did the work — even though the cash hasn't landed in your hand yet.
Step-by-Step Example
- 1 You deliver $1,000 of product to a customer in December.
- 2 The customer agrees to pay you in February.
- 3 Under accrual accounting, you record $1,000 of revenue in December — the moment you delivered the goods.
- 4 Under cash accounting, you'd record $0 in December and $1,000 in February — whenever the cash actually arrives.
- 5 This is exactly why a company's profit (accrual-based) and its actual cash in the bank can tell two very different stories at the same moment in time — which is what the Cash Flow Statement is designed to reveal.
A company that ships $1 million of product in December but doesn't get paid until February still records that $1 million as December revenue under accrual accounting.
Quick Recap
- ✓ Accrual accounting is required under GAAP for most public companies.
- ✓ This is precisely why a profitable company (on paper) can still run out of cash.