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A system of accounting that recognizes revenue and matches it with the expenses that generated that revenue. Unlike other systems of accounting, which recognize revenue and expenses in the order in which they are received, the accrual accounting convention ignores the function of time and only considers what expenses generate what revenues, even if payments have not actually been made. Companies with inventories are required to use the accrual method for tax purposes.
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A method of accounting that recognizes expenses when incurred and revenue when earned rather than when payment is made or received. Thus, it is the act of sending the goods or receiving an inventory item that is important in determining when transactions are posted on financial statements. For example, using accrual accounting, sales are recorded as revenue when goods are shipped even though payment is not expected for days, weeks, or months. Most firms use the accrual basis of accounting in recording transactions. Compare cash basis accounting.
Case Study Recording revenues that are used to calculate earnings before actually receiving those revenues can potentially misrepresent a firm's financial results and lead to financial difficulties down the road. For example, a company that ships substantial amounts of goods on credit may produce outstanding earnings in the current accounting period, but if customers who receive the goods fail to pay for the merchandise, future earnings are likely to suffer. Firms build an estimate for doubtful payments into the revenues and earnings they report, but the estimates may be understated and make earnings look better than they actually are. More than a few companies have been known to ship unusually large amounts of merchandise near the end of a fiscal year in order to make the year's sales and earnings appear favorable even though the extra sales produce an unrealistic picture of the firm's operations. In one instance, a large toy company was offering special incentives to customers that loaded up with the firm's merchandise just prior to the end of the year. This, of course, is perfectly legal. However, the company offering the incentives was accused of overstating its earnings by not properly accounting for the expense of the incentives being offered. A firm that aggressively pursues end-of-year sales may end up selling to some financially weak customers who fail to pay for the merchandise. Unfortunately, it is difficult for stockholders to know the extent to which a firm's actions serve to puff up the financial statements rather than produce real results.
Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.