One of the areas Newleaf Training and Development specialize in is, business financial intelligence — helping people understand how their work impacts their organization’s money-making model. Within this type of training, we help people build an intrapreneurial mindset and skillset. I mean, can you imagine and organization where every employee is working as if they own the business? It would be amazing. As the cool kids say, it’d be “cray-cray”.
Part of the business financial intelligence training we do is focused on jargon busting. You see, like all work functions, accounting uses jargon. One piece of jargon that I have found is commonly heard yet commonly misunderstood is the word accrual. We hear accountants all over the world, usually around month-end muttering about whether to accrue or not accrue. This seems to more intense at year-end, but why? Well to answer the why, we need to ensure we understand the what.
There are two types of accounting — the cash basis of accounting which simply put is used by super-small organizations when there’s little to no time delay between them buying their inventory and selling it. The cash changes hands pretty quickly. I have a friend (honestly I do), who is a florist. She buys her inventory and pays cash for it immediately. She sells the flowers the same day and guess how she gets paid? Yep in cash, or by a debit or credit card which to her of course, is all good as it’s all cash. She doesn’t purchase her inventory on account (accounts payable), she pays cash. She doesn’t sell her inventory on account (accounts receivable), she collects cash immediately. Therefore, she uses the cash basis of accounting, meaning she records (or her bookkeeper records) the purchase and sale of inventory when the cash changes hands.
Most organizations of course purchase items on account and sell things on account. Additionally they will often pay for items in advance (i.e. they may prepay their insurance) or they may receive payment in advance (i.e. a customer deposit). So the accrual basis of accounting better serves these organizations. Your organization (unless you’re a super-small cash-based business) uses the accrual basis of accounting.
For extra credit with your accounting department, see if you can track with me on this: there are four possible adjustments at month-end or year-end that get the accountants excited as whether they need to make a transaction in the books of the business or not:
1. Prepaid expenses – like I mentioned above, if your organization prepays certain items before they’re used (i.e. insurance) they have what is called a ‘pre-paid expense’. When they pay for their insurance, cash goes down but pre-paid expenses (which are really assets) increase because they own the insurance cover. As the insurance gets used up the pre-paid expense decreases and the actual insurance expense increases. So pre-paid expenses are REALLY assets that turn into expenses as they’re used.
2. Unearned revenues – if your organization receives partial payment in advance for a product or service, their cash goes up but they can’t treat it as income yet because it’s not been earned. What they have is a liability because they owe the customer that product or service. As they commence to do the work, the liability goes down and income goes up. So unearned revenues are REALLY liabilities that turn into income as they’re earned.
3. Accrued revenues – if your organization sells items on account (meaning there’s a delay between you providing the product or service and you being paid), you’re dealing with accrued revenues. Income goes up when you provide the item (as you’ve earned it) and accounts receivable goes up because you own the right to payment. As soon as you get paid accounts receivable goes down and cash goes up. So accrued revenues are REALLY assets that cause an inflow of cash when it’s paid for by the customer.
4. Accrued expenses are the opposite of accrued revenues. These are when you purchase something on account meaning there’s a time delay between you receiving the product (i.e. inventory) and you paying for it. When you first purchase something, what you bought increases (i.e. inventory) and your liabilities (i.e. accounts payable) increases. When you eventually pay for it, the liability goes down and your cash goes down. So accrued expenses are REALLY liabilities that cause an outflow of cash when you pay the vendor.
So we perhaps better understand WHAT accruals are…but WHY does it matter? Well, we want to ensure that if we’ve earned something it’s treated as income and if we’ve used something it’s treated as an expense. When we have those two right (income and expenses), we know whether we’ve made a profit (income > expenses) or a loss (expenses > income). We also want to make sure that what we own (assets) and what we owe (liabilities) are correctly represented on the balance sheet and that the balance sheet actually…err…balances.
So, I hope that this has helped you understand a little bit more about why accountants are always asking themselves (and anyone else who’ll listen), “Accrue or not to accrue — that’s the question” They’ll be totally impressed now when you can respond to their question with perhaps a greater command of the jargon. Like my friend the florist, you’ll likely have a new friend in accounting.