Accrual Accounting Explained

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The "accrual" method of recognizing sales is an important concept to understand, because under this system, a company might not have actually received the revenues on its income statement.

Revenues don't necessarily represent the receipt of cash in a sale. Many firms "accrue" revenues -- booking sales when goods are shipped, when services are rendered, or as a long-term contract proceeds through stages of completion.

Imagine the company Beehive Wigs (ticker: MARGE). With the accrual method, if it has shipped 1,000 crates of wigs but hasn't yet received payment for them, those sales still appear on the income statement. The checks "in the mail" get reported as "accounts receivable" on the balance sheet.

Keep an eye on receivables, to make sure a company isn't booking as sales that which it cannot collect. Also make sure it's not packing sales into this quarter that really belong in the next quarter.

Rex Moore discussed how to evaluate companies and get accrual accounting issues in his article "Cash Isn't a Cruel Measure." Bill Mann addressed it a bit in this article, where he dissected Microsoft's (Nasdaq: MSFT) revenues.

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