What Is Accrual Accounting?
Accrual accounting is required under both U.S. GAAP and IFRS. Revenue is recognized when earned (performance obligation satisfied) and expenses when incurred (economic benefit consumed), regardless of cash timing. This contrasts with cash-basis accounting, where transactions are recorded only when cash moves.
The Matching Principle
Expenses should be recognized in the same period as the revenues they help generate. A company paying $12M for annual insurance does not expense it all at once — it records $1M monthly. The remaining balance sits as a prepaid asset.
Revenue Recognition (ASC 606)
ASC 606 uses a five-step model: identify the contract, identify performance obligations, determine transaction price, allocate price to obligations, and recognize revenue as obligations are satisfied.
Why Accrual Accounting Matters for Banking
Financial statements are on an accrual basis. The gap between accrual earnings and cash flow is critical. A company can be profitable while running out of cash (if AR grows faster than collections). Conversely, a company can show losses while generating strong cash flow (high D&A or growing deferred revenue).
The cash flow statement reconciles net income (accrual) to actual cash generated. Understanding how to move between accrual and cash metrics is fundamental to financial modeling and valuation.
Key Accrual Items
Accounts Receivable: revenue recognized before cash collected. Deferred Revenue: cash collected before revenue recognized. Prepaid Expenses: cash paid before expense recognized. Accrued Liabilities: expenses recognized before cash paid. Depreciation: past cash outflow recognized as expense over time.
Each creates a difference between the income statement and cash flow statement, and IB interviews frequently test these linkages through three-statement questions.