IT Financials Glossary

Accruals

Posted in Accounting by mgentle on August 26, 2010

Accruals: enable revenue or expenses to be recognized before payment occurs.

If you’ve heard the term accruals before, it was probably associated with the year-end close, when all departments have to ensure that their unpaid invoices are booked to the financial year about to end. But accruals can also be used during the financial year to track costs with respect to budget, as we shall now see.

There are two types of accruals:

  • Accrued revenue: revenue is recognized when it is earned, which most of the time is before payment is received.
  • Accrued expenses: expenses are recognized when they are incurred, which is usually before the invoice is paid.

This form of accounting is called accrual accounting (the norm in any large company), as opposed to cash accounting (often used in small businesses), which only recognizes revenue and expenses when cash changes hands. Understanding cash accounting helps to appreciate the usefulness of accruals.

Cash accounting

In the following example, Fig. 6.2a  (NB click on the image to get a full-screen view) shows how cost management with cash accounting results in an incorrect situation with respect to budget. Because the invoice for work incurred in January will only be paid in February (assuming payment terms of one month), the snapshot for the end of January shows zero costs. Of course, this is incorrect, because, to take an extreme example, if the project were cancelled at the end of January, the vendor would still have to be paid. Continuing with this cash-based approach, by the time we get to March, the YTD costs give the impression that only $220k has been spent (ie, 150+70), whereas in reality it is $470k (ie, 150+70+250).

Accrual accounting

Fig. 6.2b (NB click on the image to get a full-screen view) shows how accruals capture the true cost situation with respect to budget. January work is accrued at the end of January, thereby recognizing the expense the month it was incurred, regardless of when the invoice is eventually paid. By the time we get to March, the YTD costs are correctly shown as $470k (ie 150+70+250).

Accruals can be thought of as “pre-booked actuals” pending payment, thus enabling more meaningful financial reporting. They are reversed once payment has occurred.

In accounting software systems, accruals can be generated after the corresponding goods or services have been received.

In this simple example, invoices are submitted quickly and paid one month later; in the real world, they could be submitted late and paid late. Without accruals, therefore, your financial reporting would not only be inaccurate, but it could also become unpredictable because it is based on when vendors submit their invoices (surprisingly, not always on time) and when these invoices are eventually paid (dependent on payment terms and on process inefficiencies).

Accruals vs commitments

The alternative to using accruals to track uninvoiced work is to use commitments instead, which is simply uninvoiced work recorded in the management accounting system. An accrual goes one step further and records the commitment in the financial accounting system.

The big advantage of an accrual is that once it is recorded, it is “on the books”, and relieves you of the burden of tracking the commitment through to when the invoice is eventually paid – with the attendant risk of double-counting, ie recording both the commitment and the paid invoice against your budget.

FURTHER READING: for an accounting view of accruals – which is both understandable and entertaining – check out the following article by Michael Sack Elmaleh.

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