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Accruals

Definition:

An accrual is the portion of a revenue or expense item that is recorded in a particular time span. Product development costs, for instance, are likely to be spread out over several accounting periods, and so a portion of the total cost will be accrued each month. The purpose of accruals is to match costs to revenues in a given time period as accurately as possible. Determining accruals and allocations nearly always entails making assumptions and estimates.

 

Example:

Let’s use your salary as an example. Say that you worked in June on a new product and that the new product was introduced in July. The accountant determining the allocations has to estimate how much of your salary should be matched to the new product cost and how much should be charged to development costs. They must also decide how to accrue for June versus July. Depending on how they answer questions such as these, they can dramatically change the appearance of the income statement. Product cost goes into cost of goods sold. If product costs go up, gross profit goes down which affects product profitability. Development costs on the other hand go into R&D which is an operating expense and doesn’t affect gross profit.

 

Book Excerpt:

(Excerpts from Financial Intelligence, Chapter 2 – Spotting Assumptions, Estimates, and Biases)

Accountants use accruals and allocations to try to create an accurate picture of the business for the month. After all, it doesn’t help anybody if the financial reports don’t tell us how much it cost us to produce the products and services we sold last month. That is what the controller’s staff is trying so hard to do, and that is one reason why it takes as long as it does to close the books.

 

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