This week I dive into the wonders of accrual accounting!
VIDEO SUMMARY
In this video we are talking about accrual accounting. What I want is to get you to realize the beauty of this concept. This is one of those key concepts you have to understand if you are going to work in accounting or finance.
Let’s start with the definition. Accrual accounting reports financial statements based on economic events rather than when cash transactions occur. This means that if you issue a financial statement for one year, it should reflect what actually happens in a business during that year rather than simply the cash going in and out of your bank account.
This definition is so important to understand because most financial statements use accrual accounting. For instance, a company whose stock is publicly traded is required to have financial statements based on accrual accounting. The alternative is generate financial statements on a cash-basis, and many small businesses do this, because it is easier. You need to understand why larger companies use accrual accounting, and the benefits.
I would like to start with an example that shows the difference between a cash-basis and accrual accounting. Let’s say you own a consulting firm. You have a team of consultants who work for you. Imagine you just landed a big new client for a year long project for 1.2M dollars. Under this new contract, you have agreed to send your team out to their location in Las Vegas, and they will pay you 100k per month. Now I know most consultants bill on an hourly rate, but this is a big, complex, yearlong project, and the contract is written with monthly performance milestones with monthly payments. So you send your team out to Las Vegas. And let’s say your team has never been to Las Vegas before. And we all know that in Las Vegas there are a lot of fun things to do. There are flashing lights everywhere. And let’s say that your team gets distracted, and they spend most of their time in the casinos goofing off. Meanwhile, you are in another city running this consulting company, and what you see is the 100k dropping into your bank account every month. So from your perspective everything is going great. You get distracted by other things and you do not realize that your team is not actually getting any work done. Three months go by. So after three months, you think to yourself, “hey, I better check on my team in Las Vegas.” So you go to Las Vegas and you find that no work has been done.
Now there are obviously organizational problems going on in this example, but I want to focus on the accounting problem. This shows why accrual accounting is important. You have 300k, but you have not done any of the work. You are still going to have to do that work, or you have to give the money back to the customer. So that 300k would be inappropriate to report as revenue earned on your financial statement. What you saw happening in your bank account, may not reflect what is actually going on in the business. You really want to know the economic activity, or what work is actually being done. You want accrual statements to reflect that.
Let’s show a comparison. In this example, if you used cash-basis accounting. You would book the 300k as an increase to cash and revenue. But if you used accrual accounting, you would book the 300k as an increase to cash and unearned revenue. Revenue recognition is a really deep subject area in accounting, and I could talk for days about it. But I want to stick with my main point about accrual accounting. What you can see in this comparison, is that accrual accounting more accurately communicates what is going on here. You have the cash, but no work has actually been done. When you actually perform the work, only then can you recognize the revenue.
The key concept here is that accrual accounting incorporates non-financial information into financial statements. This concept really explains why accrual accounting is so difficult. It would be easy if you could just generate a financial statement based on your bank account activity. You have dollars in and dollars out with exact amounts that you can place into a financial statement. That’s easy. What is difficult is then tweaking that financial statement to reflect what is actually happening in the business. So in the example, you would make adjustments to show that no work has actually been done. That is non-financial information that you will not find on any bank statement. You have to go out and talk to people.
In order to report on this non-financial information, you need some sort of reliable methodology to measure percentage of completion of your project. This gets into project management which is another deep subject area. Project management provides you status updates on three main things: budget, scope, and schedule. So you will notice here, that the money aspect is only 1/3 of what you need to know to understand the health of your project. I will talk more about project management in future videos. My point is that you take the non-financial information you get from your project manager on what work is actually being done, and you use that information to make decisions on what to report on your accrual financial statements.
From a practical standpoint, here is what happens in a business.
- Every month you close the books (or whatever period you issue financial statements)
- You receive status updates from your project managers
- Under accrual accounting, you perform “accruals.” Accruals are adjusting journal entries that adjust revenue and expenses to reflect economic activity rather than cash transactions
- Publish your accrual financial reports
So you can see here that this is a lot of work, but you are communicating what is actually going on in your business.
So why do we use accrual accounting? Isn’t cash what is really important? After all, you want businesses to generate cash. I have even made another video about the “Statement of Cash Flows” and why it is so important to understand what is happening with your cash. So why do all this extra work. The answer has to do with capital markets. In a mature business, cash is only one element of owner’s equity that is funding your company. You have cash, debt, receivables, stock ownership. What capital markets really care about is productivity. They want to understand revenue and profit each period. They want to know what is actually going on the business. So accrual accounting communicates economic activity each period and reflects that activity in financial statements. What is so powerful is that accrual accounting is what makes capital markets possible. Without accrual accounting, people wouldn’t be able to look at companies and understand their level of productivity.
Thank you for watching. Leave a comment down below letting me know what you think! The best way to supercharge your business is through accounting and corporate finance. I release a new video every week, so come back and check out next week’s video.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.