Accruals are a cornerstone concept of modern accounting, representing adjustments for revenues that have been earned and expenses that have been incurred, but for which cash has not yet been exchanged. This is the essence of accrual accounting, which stands in contrast to the simpler cash basis accounting where transactions are only recorded when money changes hands. Think of it like this: if you sell a product on credit in December, accrual accounting lets you book that revenue in December (when you earned it), even if the customer doesn't pay you until January. Similarly, if you owe an employee a bonus for December's work but don't pay it until January, the expense is recorded in December. This method provides a much more accurate snapshot of a company's financial performance and health over a specific period, matching revenues to the expenses that generated them, rather than being skewed by the sometimes-lumpy timing of cash payments. For an investor, understanding accruals is the first step in looking beyond the headline earnings number to see the true story.
A seasoned value investor knows that not all profits are created equal. The central mission is to find companies with high Earnings Quality, and accruals are the primary tool for this investigation. Why? Because accruals are, by definition, non-cash components of earnings. A company can use aggressive accounting techniques to report spectacular profits on its Income Statement, but if those profits aren't backed by actual cash flowing into the company's bank account, they might be an illusion. Imagine a company that books massive sales at the end of a quarter by offering very generous credit terms to customers. Its reported earnings look fantastic. However, the cash hasn't arrived. These paper profits are high-accrual earnings. If those customers later default, the profits evaporate. The statement of cash flows is your best friend here. It cuts through the accounting noise and shows you the cold, hard cash. The difference between a company's Net Income (from the Income Statement) and its Cash Flow from Operations (CFO) (from the Statement of Cash Flows) is largely made up of accruals. A large and persistent gap between these two figures is a major red flag.
You don't need a PhD in accounting to get a handle on a company's accruals. There are two straightforward methods investors can use.
This is the most direct and popular method for a reason. You simply take two numbers straight from the financial statements to calculate what's known as Total Accruals.
This method looks at the change in a company's operating assets and liabilities over a period. It's a bit more work but can offer additional insights into the source of the accruals.
Let's consider two hypothetical widget makers to see how this plays out.