What is Accrual Accounting?
Accrual accounting recognizes revenue when earned and expenses when incurred, regardless of when cash actually changes hands. A sale is recorded when goods are delivered, even if payment has not been received. An expense is recorded when a service is consumed, even if the bill has not been paid. All publicly traded companies use accrual accounting, which creates the gap between reported profits and actual cash flow that investors must understand.
What Investors Should Watch
Rapidly growing accounts receivable may indicate revenue is being booked but not collected, or that uncollectible sales are being recorded. Surging inventory suggests products are not selling as fast as they are being produced. Large accruals (the gap between net income and operating cash flow) signal that reported profits may not be sustainable. These warning signs are visible in the balance sheet and cash flow statement.
The Three-Statement Analysis
The income statement shows what a company earned under accrual rules. The cash flow statement shows what actually came in and went out. The balance sheet shows the cumulative result. Analyzing all three together reveals whether profits are real. When net income consistently exceeds operating cash flow, be skeptical. When cash flow exceeds net income, the company likely uses conservative accounting, a positive signal for investors.