Final answer:
Accrual accounting is a method where revenue is recognized when earned and expenses are recognized when consumed, regardless of when cash transactions occur. This approach differs from cash accounting and helps to accurately reflect a company's financial performance by aligning revenue with related expenses.
Step-by-step explanation:
Recognizing revenue when it is earned and not when cash is received, and recognizing expenses when the related goods or services are used rather than when they are paid for, is called accrual accounting. This method is contrasted with cash accounting, where transactions are recorded when cash is received or paid. In accrual accounting, revenue is recorded when it is earned, which may occur before the money is actually received. Similarly, expenses are recognized when the goods or services are consumed, not necessarily when they are paid for.
This concept is important in understanding the difference between accounting profit and economic profit. Accounting profit calculates total revenue minus explicit costs, the actual cash transactions. On the other hand, economic profit considers both explicit and implicit costs, the latter of which includes opportunity costs and other non-cash expenses.
By using accrual accounting, businesses are able to more accurately match revenue with the expenses incurred to produce that revenue, which provides a clearer picture of the company's financial performance.