Accrual accounting is an important concept to investors’ understanding of earnings. Since earnings drive stock prices, understanding something about how earnings are measured is surely relevant to investing in common stocks. Accrual accounting is the basis by which earnings are measured under generally accepted accounting principles (GAAP).

Not all income (earnings) in this world is measured on an accrual basis. For example, individual taxpayers largely determine their taxable income reported on their tax returns on a cash basis of measurement per Internal Revenue Service (IRS) code. State and local governments follow governmental rules that require them to set up certain governmental funds that measure inflows and outflow by a basis called modified accrual accounting. Suffice it to say that there are different ways to measure income. But accrual accounting is the way earnings are measured when it comes to the financial reporting of companies publicly traded over U.S. stock exchanges.

In this week’s post and for the next several posts, I’ll discuss the main parts of accrual accounting. I’ll talk about what revenues and expenses are and about when they are recorded.

Some months back I mentioned a financial practice called taking the “big bath” whereby some companies time their revenues and expense recordings in such a way as to throw the kitchen sink of bad stuff into an otherwise already bad earnings quarter in order to have the future quarters look that much better. The plausibility of timing the booking of revenues and of expenses, as is found in the “big bath application, in the process of measuring income (earnings) is actually found in the practical meaning of accrual accounting.

Simply, if one is going to invest in individual stocks, it is of paramount significance to note that financial accounting produces a set of numbers that go on a set of statements. Using those statements properly requires some understanding of how the numbers are derived.

For this initial post about accrual accounting, note that accrual accounting is a system or basis of measuring earnings, as required under GAAP by companies filing with the SEC, for reporting via a financial report referred to as the Income Statement. Other common business jargon names for the income statement are the earnings report, and the profit/loss report.

While a stock share gives one the right to participate in future earnings, that very right exists because a stock share is an ownership stake. It is an equity stake and equity is ownership. Without the balance sheet, earnings have no real meaning to the stockholder. The balance sheet is the company’s financial house; the goal is to increase the size of the financial house through earnings. Per my book, “Choose Stocks Wisely,” when one buys the right to participate in future company profits via acquiring a share of stock, one should also recognize that he/she is buying an equity stake and seek to assure that ample equity already exists on the balance sheet to justify the ticket price.

Have a good week.