Chances are, at some point in your life you've subscribed to a newspaper or magazine. Most likely, the newspaper or magazine publisher asked you to pay for the cost of the entire year's worth of issues at the beginning of your subscription. However, when the publisher received your up-front payment, it was not allowed to record the entire amount of cash that you paid it as revenue.
The above occurrence highlights the concept of accrual accounting, the accounting method used in the United States by publicly traded companies. Accrual accounting attempts to recognize revenue and expenses in the specific period in which they occur. For instance, accrual accounting recognizes revenue in the period in which the company sells its goods or actually provides its services. In our newspaper subscription example, the publisher recognizes revenue from your subscription gradually over the length of the subscription. So, in effect, the publisher is still recognizing revenue from your subscription weeks and even months after receiving your payment.
Accrual accounting is also applied to reflect the purchase and use of a large piece of equipment or a building. When a company purchases such an asset, it does not record the entire cost of the asset as an up-front expense that runs through the income statement. Rather, it records the purchase price of the asset on the balance sheet. Then, each year, it takes a portion of that asset's cost and expenses it on the income statement as a depreciation expense.
Depreciation expense, which represents normal wear and tear for an asset (much as your car depreciates a little each year), reduces the recorded book value of the asset every year (very similar to how the value of your car goes down the longer you keep it). Keep in mind that depreciation is a noncash expense because the cash outlay already occurred when the asset was purchased and recorded on the balance sheet.
Accrual accounting allows revenue and expenses to be recognized in the appropriate periods, letting a company match as best it can its sales with the expenses incurred in generating those sales. As you can see, cash in the door does not always mean immediate revenue for a company, and cash out the door does not always mean immediate expense for a company, either. Keep this important concept in mind as you analyze any company's income statement.
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