Demystifying Accruals
Accruals are an everyday part of an accountant’s life, but can seem cryptic to the non-accountant. I looked up the definition of accruals, and although the definition explains what they are, it doesn’t explain why they’re used.
Accruals have everything to do with the matching principle, one of the basic building blocks of accounting that’s taught in introductory courses. The matching principle can best be explained by first setting up an example.
You start a business building and selling bird houses on January 1. You go to the home improvement store and purchase wood, nails, paint, and everything else you need to build 10 bird houses. The bill comes up to $100, resulting in a cost of $10 per bird house. By the end of the month, you complete building 5 bird houses and do not sell any.
If you use cash basis accounting (the “opposite” of accrual accounting), you record transactions when money comes in or out and the entire amount is either recognized as revenue or expensed. So for January, your profit and loss statement would look like this:
Revenue $0 (no sales)
Direct Costs $100 (your material purchases for the month)
Net Loss ($100)
Doesn’t look good or fair, does it? Under accrual accounting, you would have no profit and loss statement because no bird houses have been sold yet. Instead, you would have a balance sheet that looks like this:
Assets
Raw Materials $50 (material left that hasn’t been built)
Finished Goods $50 (5 bird houses built X $10 cost per bird house)
Total Assets $100
Owner’s Equity $100 (Your investment in the business)
Let’s move on to February. You build the remaining 5 bird houses with the materials you have and you sell 7 bird houses for $20 each. No additional material purchases were made for the month. Your cash basis February profit and loss statement looks like this:
Revenue $140 (7 bird houses sold X $20)
Direct Costs $0 (No purchases were made for the month)
Net Profit $140
Now your profit is overinflated. It doesn’t take into account the cost of building the bird houses you sold because you purchased the material in the prior month. With accrual accounting, your profit and loss would look like this:
Revenue $140 (7 bird houses sold X $20)
Direct Costs $70 (7 bird houses sold X $10 cost per bird house)
Net Profit $70
The balance sheet would look like this:
Assets
Cash $140 (7 bird houses sold X $20)
Finished Goods $30 (3 bird houses unsold X $10 cost per bird house)
Total Assets $170
Retained Earnings $70 (Net profit from profit and loss statement)
Owner’s Equity $100 (Balance remains the same from prior month)
Total Owner’s Equity $170
This is the matching principle - matching up the revenue of the items sold to their respective costs in the SAME month. The cost of unsold items are put in inventory accounts on the balance sheet, something that is not done using the cash method. The accrual method is a more accurate method of ascertaining how profitable your venture is.
Another item that is significantly affected is any kind of prepaid expense. For example, on January 1, you rent an office and have to pay 6 months’ rent in advance, $6,000. Under the cash method, the entire $6,000 would be expensed in January because that is how much money went out the door. Under the accrual method, you would expense $1,000 of that payment in January and the remaining $5,000 would be placed on the balance sheet as a prepaid asset. You would then expense $1,000 each month and reduce the prepaid asset by the same amount. This, again, is a more accurate method of determining your actual monthly costs.
If you read my previous article about depreciation, this is another example of accrual accounting. Depreciation represents the usage or consumption of a fixed asset on a per-month basis since the benefit of a fixed asset will be enjoyed over an extended period of time.
Using cash basis accounting has its benefits, but are beyond the scope of this article. I hope this gives you a clearer understanding of what accrual accounting is and what it accomplishes: relevant and useful financial reporting for better-informed decision-making.