Accrual accounting

The operating section of the cash flow statement shows the firm’s performance at a cash basis. The cash flow from operations is the amount of cash that has been generated with day-to-day operations. The period in which the cash is received or paid, is also the same as the period where it is included in computing the cash flow from operations.  This is called cash accounting.

In practice however, most organizations use 'accrual accounting'. With accrual accounting performance measurement is not solely determined by cash flows. Accounting principles such as IFRS and U.S. GAAP prescribe when revenues and expenses need to be recorded.

Accrual accounting: allocating cash flows to periods

The income statement is based on accrual accounting. This means that it is not necessary that the cash flow is in the same period as the revenue/expense. In other words, with accrual accounting cash flows are allocated to periods. When a customer pays money to the firm, this cash inflow can be a revenue in a period prior to the cash inflow, the same period, or a future period. The same holds for cash outflows: a cash outflow can be expensed in a period prior to payment, the same period, or a later period. Accounting principles (discussed next) determine the period to which the cash flow is allocated.

With accrual accounting, any possible transaction can be classified in either of six possibilities, which are shown in the figure below. In the upper half, it shows the three possible treatments of cash outflows. In the lower half, it shows the possibilities for cash inflows.

accrual accounting overview

In the first column, the period of the cash flow is the same as the period of the expense/ revenue. In this column, accrual accounting yields the same result as cash accounting.

In the second column we see deferred accruals. That means, the period of the expense/revenue is in a later period than the cash flow. In case of a cash outflow the payment is capitalized as an asset, because it is considered to have future value. In a later period, when the asset is reduced in value, the asset is expensed. In the case of a cash inflow, a liability is increased. As the cash is received, but the firm has not delivered/rendered the products/services, the firm will have an obligation to do so. In a later period, when the firm has fulfilled its obligations, the liability is reduced and revenue is recognized. In both situations, we see that the cash flow is ‘parked’ on the balance sheet. That’s where the ‘accrual’ in ‘accrual accounting’ is coming from: cash flows accrue to the balance sheet.

The opposite situation is depicted in column three. In a period prior to the cash flow, the expense/revenue is recognized. The resulting ‘accruals’ are called ‘accrued accruals’. The term ‘accrued’ refers to the fact that the cash flow is anticipated. In the cash of an anticipated cash outflow, an expense is recognized in an earlier period. At the same time of the expense, a liability is recognized. The liability reflects the fact that the firm has an obligation, in this case, to pay money. When the money is paid, the liability is reduced, and cash is reduced. In the case of an anticipated cash inflow a revenue is booked in an earlier period than the period of the cash inflow. At the time of the revenue, an asset is recognized to reflect the fact that a customer will pay money to the firm in the future. At the time of the cash inflow, this asset is reduced (because the customer has paid), and cash increases. Again, the balance sheet is used to bridge timing differences between the time of the expense/revenue and the time of the cash flow.

Key points:
- Cash accounting: the expense/revenue is recognized at time of the cash flow
- Accrual accounting: cash flows are allocated as expense/revenue to periods using accounting principles
- Deferred accruals: the expense/revenue is in a later period than the period of the cash flow
- Accrued accruals: the expense/revenue is in a earlier period than the period of the cash flow
- The balance sheet is used to bridge timing differences between the period of expense/revenue and the period of the cash flow

Two main principles of accrual accounting

Accrual accounting is very flexible, and as a result it is open to manipulation. However, accounting principles restrict this flexibility so that the financial statements reflect the economic reality. (Large firms have their financial statements audited by an external auditor for increased assurance that the accounting principles have been applied correctly.)

There are two main accounting principles: the revenue recognition rule determines in which period incoming cash flows need to be recognized as revenue and the matching principle tells in which period an outgoing cash flow needs to be expensed.

The revenue recognition principle states that revenues are earned in the period where the product is delivered or the service has been rendered, regardless in which period the customer pays the firm.

The matching principle states that cash outflows should be booked as an expense  in the period where they help to generate revenue.

Key points:
- accrual accounting is very flexible; accounting principles limit this flexibility so that opportunities to cook the books are restricted, and, (ideally) the financial statements represent the economic reality
- the revenue recognition principle states that revenue is earned in the period when the products are delivered or services rendered
- the matching principle states that expenses need to be booked (‘matched’) in the period where they help to generate revenue

Continue with reading the next tutorial: Inventory



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