Accrual Method of Accounting
The financial statements distributed by U.S. companies must comply with the U.S. generally accepted accounting principles (GAAP or US GAAP). One of perhaps 1,000 rules in US GAAP is a requirement that the income statement be prepared using the accrual method of accounting.
The accrual method of accounting is also referred to as the accrual basis of accounting, or accrual accounting. (The accrual method is different from the cash basis or tax basis.)
For the income statement, the accrual method means:
Revenues are reported (recognized) on the income statement in the accounting period when they are earned, which is often different from the period when payment is received from the customers.
For example, if a company delivers products to a customer in December 2020 but the customer is allowed to pay in January 2021, the company will report the sale as part of its December's revenues.
Common examples of revenues include the sales of products to customers and providing services for clients.
Expenses are the costs and expenses incurred to earn the company's revenues during the period of the income statement. It is common for an expense to be reported on the income statement in an accounting period different from when the company paid out the money.
For example, in June a retailer purchased and paid for products at a cost of $6,000. In July, the retailer sells the products for $10,000. There was no expense reported on the June income statement since none of the products were sold. (The $6,000 cost reduced the retailer's cash and increased its inventory, both of which are reported on June's balance sheet.) The retailer's July income statement will recognize the expense cost of sales $6,000 as necessary to earn the $10,000 in sales.
Some costs will not be directly caused by sales and must be allocated. For example, a retailer may have purchased a delivery truck two years ago at a cost of $60,000. The truck was expected to be used for 60 months and have no salvage value. Therefore, every month for 60 months, the retailer's income statement will report depreciation expense of $1,000.
Other costs such as salaries, advertising, rent, utilities, etc. have no future value that can be measured. Those costs will be reported as expenses when the costs are incurred or used up. In other words, July's rent and utilities will be reported as an expense on the July income statement (even if the utilities used in July will be paid in August).
A gain is reported on the income statement when a company sells a long-term asset for more than the asset's book value. For example, if a company sells its old delivery truck for $10,000 and its book value was $6,000, the income statement will report a $4,000 gain on the sale of the truck.
A loss is reported on the income statement when a company sells a long-term asset for less than the asset's book value. If the company sells its old delivery truck for $5,000 and its book value was $6,000, the income statement will report a $1,000 loss on the sale of the truck.
Net income or net earnings is the amount by which the income statement's revenues and gains exceeded the amount of expenses and losses. A net loss is reported when revenues and gains were less than the amount of expenses and losses.
It is important to understand that the income statement's focus is to report a company's profitability during a relatively short time interval such as a month, three months, six months, a year, and so on.
The income statement does not report the company's cash receipts and disbursements. To learn about the cash amounts, users should review the company's statement of cash flows. (You can learn more about that financial statement by visiting our topic Cash Flow Statement.)