Tell me something, do we live in a perfect world? Is every day just sunshine and every night a veritable kaleidoscope of celestial splendor? The answer is no. Anyone who says otherwise is selling something. Because we do not live in a perfect world, we must set up safeguards for ourselves, and in the world of business, one of the most powerful safeguards is accrual. Accrual is a vital accounting strategy specifically designed to keep a business on the positive side of cash flow and ensure it lives to see another day, sunny or not.
So, what is Accrual?
In basic terms, accrual is when a company has revenue to be gained or expenses to be paid, which are both recorded, but the company has yet to pay. What does that even mean? Stop talking in gibberish! It basically means that a company acts like the money has already come in and out even if it has not actually done so. This is done because, as previously stated, we do not live in a perfect world, and as such money due is not always received in the same moment it is earned. I.E. you accrue the revenue or expenses.
By matching expenses and revenue to when they are earned, it provides companies a much more accurate idea of their financial status, rather than just a balance sheet of the present. Accrual can act like a crystal ball for the future, giving insight, mystical or not, into the future of their revenue stream and profit.
SA common competitor to accrual is cash accounting. Cash accounting is the INFERIOR method of recognizing a transaction when the cash is actually paid. Now you may be thinking, but surely that makes more sense! Don’t spend money you don’t have! The issue is cash accounting commonly paints an inaccurate picture of a company’s finances. With cash accounting, upcoming expenses and transactions are not considered in the pure cast-iron truth of a financial statement. As such, this can lead a company to spend money it believes it has, as expenses have not been considered, and short themselves.
So, what should you use?
I recommend learning and understanding accrual accounting, for knowledge of the future is power in the present, and you can trust me! I’m the smartest person in the room! Wait, another person walked in … ok, they are gone. I am the only, I mean smartest person in the room, so I know what I am talking about.
Now that we have a basic understanding of what accrual is, let’s go into a bit more about the actual accrual of the two categories: revenue and expenses.
Accrual of Revenue
Accrued revenue (which can include non-cash assets alongside regular assets) is any income which are to be received, but the transaction of actual cash money dollars has not occurred. Instead, the goods and services are delivered, and the company takes on credit that they will, in fact, receive money for the product. Now as a company has the credit for the good, they record the amount of the future gain when they received the credit, and the good went out, and thus the company is able to accurately predict their financial status in the future, while paying current expenses, despite not having been paid yet.
Accrual of Expenses
In the same way a customer purchases a good on credit with the accrual of revenue, for expenses the company does much the same, taking on the role of the customer. By purchasing materials for its overhead and fixed costs of operation, a company using accrual accounting records these transactions as an accrued expense and thereby acknowledges the need to pay the supplier in the future. The debt to the creditor grows with each expense accrued, and as it is recorded, the cost does not come at a surprise when it comes to finally needing to pay, or when the mob goons come and rearrange the office for not receiving the money on time.
Accrual: A cruel lesson?
The generally accepted accounting principles (or GAAP) prefers companies to use the accrual method of accounting, as it provides greater accuracy in the keeping of ledgers and books, and more transparency in regards to a company’s financial health. While cash accounting may be suitable for smaller companies and organizations, it becomes an essential for larger, more complex, companies.
Companies which accrue a great many expenses and only receive credit would appear to have nothing but losses through cash accounting, but accrual accounting would show the payments which are to be received, and a far more positive light. This can be a vital tool in acquiring investors, for instance.
Despite its advantages over cash accounting, many companies still do not employ the use of accrual in their accounting and ledger keeping. Now you may wonder…why? Well, there are a few theories but a predominant one is that the concept of accrual is not well taught and understood.
The basic concepts are easy enough, but overall the true benefits are not properly explained to a great many people. Business is a fast-moving world, and business owners are constantly under pressure to make decisions in the moment. There can be no condemnation to the one who chooses to make an urgent decision based on current funds, and as such cash accounting seems to be a proper system to make such decisions, but while the present may be taken care of, it is the grim specter they need fear. Their name is Future and their scythe is financial obscurity.
We hope you enjoyed this article and, if nothing else, you experienced the accrual of some knowledge.