Why Accounting Needs Your Accruals

Managers across the country dread the call from accounting at this time of year — we need your accruals. Many managers feel that the process of putting together their accruals is tedious, and, dare we say, a waste of time. They wonder, “Why does accounting need this information? Is this another piece of information that goes into the black hole of a spreadsheet, never to be seen again?”Accruals, especially at this time of year, are critical to good accounting. They help to ensure you have good information about the financial health of your company. And, they help to keep the books “clean,” that is, keeping things that happened in 2009 in 2009 so that the picture your company presents with its financials tells the 2009 story in its entirety.

At its core, accrual accounting is fairly simple: the numbers in financial statements should reflect the work and activities that occurred in the time period of those statements. So, if the income statement is for December, then the revenue and expenses in that statement are for the revenue that was earned (for example, was the product delivered in December?) and the expenses that it took to make that revenue (for example, the cost of materials for the revenue that was earned in December). (A related and important accounting principle here is the matching principle: match expenses to the revenue the expenses helped to bring in.)

Here’s the problem: invoices, bills and cash don’t always line up in the same month the activities occurred. Say an invoice comes in for something that happened a month ago. It should have been “accrued for,” so that, even though there wasn’t any invoice, the amount is in the books for the month that the activity occurred. On the revenue side, say a product was delivered, but the client didn’t pay until two months later. That revenue had to be “accrued” for in the month of delivery, even though neither the invoice, nor the payment for the product happened in that month.

Another example of accruals is when we pay for something in one month, but we get the benefit for more than just that one month. Say you pay your insurance bill for the whole year in January. That insurance covers 12 months, not just January. So, the company accrues for that, and the books reflect 1/12 of that payment in every month of the year.

Too much accounting? Just remember that you are part of the process of creating as close a picture as possible of what happened in 2009. And that is important for a whole host of reasons, because the financial statements are used to help make lots of decisions, including those about hiring (or layoffs), raises, capital purchases, new product plans, and so on.
Finally, here are four key things to remember about accruing:

1. 1. Accruals can apply to revenue, operating expenses and capital expenses. Salaries can be a big part of accruals.
2. 2. You don’t need an invoice to accrue. You do need to know how much the invoice will be.
3. 3. You may have to make assumptions and include estimates in your accrual numbers. That’s OK, just document them.
4. 4. Think about the activities that occurred in 2009, and make sure they are reflected in the books for 2009. There may be some projects that go into 2010. Work with your accounting department to decide how to handle those.

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Originally posted in the Harvard Business Review: Karen Berman is founder and co-owner of the Business Literacy Institute, with Joe Knight. Joe is CFO at Setpoint Companies. They are the authors of Financial Intelligence.

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