Accrual Accounting and the Income Statement, Balance Sheet, and Statement of Cash Flows

A mental mapping of the Accounting Equation and the T-account, that I learned fifteen years ago when I began my foray into accounting, always helped me link the usage of the three statements together. At a high-level overview I present it below.
 
 
Economic activities of the company are recognized in the period they are incurred, generally marked by the month end, regardless of when cash exchange takes place.  This implies that cash exchange can take place before, at, or after, an activity and this timing must be reflected in the accounting statements. 
 
In order to track the economic activity accounting bookkeeping has developed the double-entry accounting method and the familiar T-accounts comprised of debits and credits; all economic activities that trigger a recording are listed in the accounting journal, a debit paired with a credit, a date and the respective ledger to which the debit and credit will be assigned and recorded.  This implies that ledgers, generally, are a collection of either debits or credits that can be aggregated for a total of debits or credits in a ledger and this is exactly what happens.
 
We can use the accounting equation and its direct relation to the financial statements to further our understanding of the basics of accrual accounting.  Recall the accounting equation of
 
Assets = Liabilities + Equities

 
and take note that this is the layout of the Balance Sheet, left side is the list of assets in the order of liquidity and the right side is the list of liabilities in order of maturity followed by the equity break out.  Further note that the equation also follows the T-account order of debits and credits. The left side of the equation, Assets, are referred to as having a Debit balance, which means debits are additive to asset accounts (ledgers) and the Liabilities and Equity have credit balances, credits from the journal entries begin additive to these accounts (ledgers).
 
How are changes to the Balance Sheet from one period to the next quantified?
 
The Income Statement
 
The income statement tracks changes to the assets and liability accounts through revenue entries and expense entries.  If we consider these entries from the simplest perspective, aggregate revenue entries minus all expense entries bring us to Net Income.  Since the Net Income is a total of all the changes to the asset and liability accounts and because of the account equation, Assets = Liabilities + Equity, this Net Income will go to Equity to balance the equation.  This is called Retained Earnings.  Because of this we can expand the Accounting Equation to an incremental version.
 
Assets = Liabilities + (Revenues – Expenses)
 
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The full version being
 
Assets = Liabilities + [Paid-In Capital + (Revenues – Expenses)]
 
Due to any outside investment in the company.
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Since Equity is on the right side of the equation and is a Credit balance account and because Equity increases with positive Net Income, Revenues must be a Credit balance account and Expenses must be Debit.
 
Finally, we circle back to Accrual Accounting and the use of the Statement of Cash Flows.  In the opening of this article, it was mentioned that economic activity must be recognized in the accounting period that it occurs. Typically, this is cut off at the month end close so that all economic activity is represented from one month to the next.
 
The difficulty most people have with accrual accounting is that there are accounting entries to revenues and expenses that do not represent a cash exchange, the entries represent cash due to be paid, cash due to be received, or they are used to represent value used up or created over the period.  Because these entries are needed to recognize all economic activity in a period in a balanced fashion, remember the Accounting Equation, Assets = Liabilities + Equity, then a statement is needed to reflect only the actual cash exchanges.  This statement is the Statement of Cash Flows.
 
The accrual concept should make sense if you stick to the Accounting Equation.  If you receive an Asset increase but have not yet paid any cash, then there must be a balance in either an increase in the Liabilities or an increase in the Equity accounts. Some of the most common examples include insurance, payroll and depreciation.  We will lay each one out at a high level. 
 
Say you purchase an annual policy for general liability insurance for $12,000 (commonly used in examples because it is divisible by 12) and pay the entire premium upfront.  In this transaction you have paid all the cash immediately, but you are owed twelve months of coverage, a benefit to your company.  The initial journal entry requires you to deduct $12,000 in cash, a credit entry, but record the benefit so the financials reflect its value at cost. This is entered into what is called a prepaid asset for $12,000, a debit.  When one month goes by, you have “used” one month of this asset and the prepaid asset account is reduced by $1000.  This reduction is made using the Insurance Expense account.  The entries are a $1000 credit entry to the prepaid asset account and a $1000 debit entry to the Insurance Expense account.  The Insurance Expense would show up on the Income Statement because it is an economic activity, but it is not a cash activity.
 
Payroll for many companies is paid out every other Friday and therefore it is common to have a payroll period split from one month to the next month.  For simplicity let’s say that a pay period will include the last week in January and the first week in February.  We will assume that you pay $10,000 per week.  At the end of January, you will owe your employees $10,000 for that final week, it is a liability, but you will not pay it until the end of the first week in February when you will pay the full $20,000.  To represent this amount owed at the end of January you create an entry to reflect that you owe $10,000 for labor, an increase in liabilities.  Typically, this involves using a Payroll Expense account, a debit entry of $10,000, and Accrual Wages Liability account, a credit entry of $10,000.  Note how the expense would reduce Equity while the liability is increased, keeping the Accounting Equation balanced, and since no cash was exchanged the entry is simply marking cash that is due to be paid.  When the cash is paid, the opposite entries are put in each account to reverse it.
 
Depreciation is a purely economic entry and is similar to our insurance example.  When a company purchases computers, a large piece of equipment, a truck, a building or something depreciable it is classified as an asset, a fixed asset.  The entries would account for the cash paid and the asset gained.  For an example the company will purchase a piece of machinery for $120,000 and it will be paid in cash.  There is a $120,000 credit entry to the Cash Account and a $120,000 debit entry to the Fixed Asset account.  The total cost of these items is not generally allowed to be deducted from revenues in the entirety of the cost, although current legislation has changed this for many new fixed asset purchases.  In cases that the entirety of the cost could not be 100% deducted from the revenues, the total cost is expensed over time, through monthly periodic expense entries. The length of time is determined by either a useful life measure or categorized by asset type and assigned a length of time by the IRS.  If the length of time is 10 years, then each month would require an expense of $1,000.  Similarly to the insurance example, the $1,000 expense represents an economic value used up and has nothing to do with any cash exchange.  The recording entries would be a $1000 debit entry to Depreciation Expense and a $1000 credit entry to an account called Accumulated Depreciation. 
 
The Accumulated Depreciation account does exactly what its name suggests, it accumulates all the depreciation expense for assets begin depreciated.  This account is reported with the fixed assets on the balance sheet and acts as a contra account given that it holds credit entries but is listed on the asset side with the debit accounts.  This accumulated depreciation account allows for a presentation of assets on the balance sheet showing both the fixed assets purchased at their original cost and the accumulated depreciation over time.  But the point of this is that the depreciation expense is another example of a non-cash expense that is entered at the end of a period for that time period.
 
It the Balance Sheet represents the assets, liabilities and equity investment in the company at a point in time, and the Income Statement represents the period changes through revenue and expense entries until the end of the next period, then the Statement of Cash Flows translates the Net Income from the Income Statement into cash by adjusting for all those noncash revenue and expense entries that have been made over the period.  It is useful to examine where the cash changes have occurred, and cash can be obscured by all the non-cash entries.
 
The Statement of Cash Flows has three sections that track cash inflows and outflows.  There is the Operating, the Investing and the Financing sections.  The Operating Section is used for the non-cash entries from the Income Statement that adjust the assets and liabilities over the period.  The Investment Section is used for capital expenditures and investments in other company equities and debts or any loans that your company might make to another.  The Financing Section is used for cash activities related to financing, debt or equity, including sale of your stock, proceeds from sale of your debt, and repayment of principal to lenders. The total change to the cash account would come from the sum of the cash used or generated from Operating, Investing, and Financing.
 
Accrual accounting, using noncash entries, necessitates the introduction of the Statement of Cash Flows to view how changes in the Cash Account occurred over the period.  Over the years, I have found many people would look at the Net Income figure and their cash balance wondering why the two figures couldn’t be aligned.  Hopefully, the relationship between the three reports and the simple entries provides a high-level understanding for what happens in the financials and a better foundation for further knowledge development.