Any revenue expenditure that has been incurred during a specific period of time (a month, quarter or a year) but has not been paid for is referred to as an accrued expense.
In simpler words, accruals are amount payable against operating expenses. Any revenue expenditure, whether accrued or paid, is reported in the income statement as an operating expense.
However, only accrued expenses are accounted for in the balance sheet as a current liability.
To bridge this gap between the income statement and balance sheet, a statement of cash flow is prepared annually in accordance with IAS 7.
A statement of cash flow is a component of the Annual Financial Statements presented to the shareholders at the Annual General Meeting.
Statement of cash flow:
A cash flow statement elaborates all the cash transactions and reports all the incoming and outgoing cash for a specific period of time, be it a month, quarter or a year. According to IAS 7, it is prepared in a particular order.
First, we need to adjust any working capital changes and operating expenses that are recorded on an accrual basis in the income statement in order to calculate net cash flow from operating activities.
Secondly, we need to calculate the net cash flow from investing activities which includes any investments made during the year or any disposal or purchase of fixed assets.
Lastly, we have to calculate the net cash flow from financing activities which includes acquiring or paying back a loan or debt, interest and dividend paid etc.
The sum of the net cash flow from all three activities is the total net cash flow of the company for the year.
Accounting treatment of accruals:
The financial statements are based on the 5 accounting principles and hence are made on the accrual basis.
One of these principles is the Matching Principle which states that you should match each item of revenue with an item of expense.
As in, all the expenses should be matched to the inventory sold to generate revenue.
This means that you have to report expenses that are incurred during the specific period of time only whether paid or accrued.
Accruals are included in the expense amount on the income statement and reported as a current liability in the balance sheet.
Effect on the statement of cash flow:
In order to prepare the cash flow statement, we adjust the profit before tax with working capital adjustments and operating expenses and accrual is an operating expense payable.
Any increase in accruals shall be added to the profit before tax and any decrease in accruals should be subtracted from the profit before tax.
Assume that a company has an accrued rent expense of $2,000 for the year ended 2019 (2018: $3,000).
As per the matching concept, the decrease in $1,000 of the accrued liability had been recorded in the income statement in any preceding year and has no effect on the income statement for the year ended 2019.
In the balance sheet for the year ended 2019, the current liabilities and the cash or cash equivalents section would be reduced with $1,000.
Now, to bridge the gap between the income statement and balance sheet we will show the decrease of this accrued liability in the cash flow statement since the effect wasn’t shown on the income statement.
A company has an accrued utility expense of $6,000 for the year ended 2019 (2018: $4,000).
As we can see there is an evident increase in the accrued liability of $2,000 which means that the utility expense of the current period has not been paid off and will be paid in the near future.
This indicates that the revenue against which the utility expense had been allocated was earned and received but the payment for the utility expense has not been made resulting in an increase in cash flow.
Payment of accrued expenses reduces cash flow whereas the increase in accruals decreases the cash flow.