Expert: Dr. Joseph de Beauchamp - 1/17/2006

Question
How does the income statement account for interest accrual then? For example, it's possible for interest to be simply added to the original debt ammount without the company actually paying it yet. In that case the liability would grow but there would have been no actual cash flow. But this change in liability must be accounted for somehow.

Thanks in advance


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Followup To
Question -
Hello,
I am learning to read income statements. I was curious about the meaning of the "interest expense" line. For example, when the 2004 income statement for the stock LWAY says the interest expense was $31,000 does this mean that the company actually paid that interest (i.e. negative cash flow) or does it mean that the interest simply accrued (i.e. no actual cash flow)?

Thanks for you time
Answer -
Yes, it means that this was the interest paid for the period as an expense.

Dr. Joseph de Beauchamp

Answer
An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principal) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.

Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.  

  
The need for this method arose out of the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period of time affect the company's financial condition at the point of the transaction. Therefore, it makes sense that such events should also be reflected on the financial statements during the same reporting period that these transactions occur.

For example, when a company sells a TV to a customer who uses a credit card, cash and accrual methods will view the event differently. The revenue generated by the sale of the TV will only be recognized by the cash method when the money is received by the company. If the TV is purchased on credit, this revenue might not be recognized until next month or next year.

Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the sale has been made. Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known in accounting lingo as "accounts receivable" and the seller's revenue has increased.

Dr. Joseph de Beauchamp