Accruals, monthly reports, quarterly reports, these are daily terminologies I have had to deal with, in the last two years I got on my role as a project controls lead. Though frequently thrown around, the concept of accruals only became really clear to me last week, when we hit the topic on adjusting accounts during the corporate financial accounting class of the EMBA program.
Luckily, this time, I had purposed to read ahead of class. It was a fifty four page document. I must say prior to last week, I had struggled to catch up with studying the course materials, especially amidst competing priorities of work and family. On this occasion however, I was determined to understand this topic from the very beginning. Enough of struggling to follow and getting lost midway and so this time, even though I ended up reading only a couple six pages out of fifty four, it did make a huge difference in my learning.
The topic started with understanding the importance of recording revenue and expenses rightly in a fiscal year. Yes Fiscal year! Another term I got to truly understand, studying the material. A fiscal year though a 12 month period, does not necessarily mean a period of January to December of a given year. While monthly and quarterly reports are quite straightforward, I did learn they are referred to as interim reports. The concept of time periods of accounting was not new to me, but it was a concept that underpinned periodic financial statements; in that it divides the economic life of a business into artificial time periods. Thus, births the concept of interim periods and fiscal year.
Going back to the term accruals, I understood from the material that accruals refers to the recognition of revenues or expenses when they are earned, not when payments are made or received. This is referred to as accrual basis accounting. In my experience as a project control lead however, I have seen instances where accruals have been taken, not when work is earned, but when commitment is made. This is often the case, in instances where the activities have been planned to happened towards the end of the reporting window, that is, an interim period or a fiscal year. Though more commonly, it’s on the later. The correctness of this practice remains a dilemma to me. As I do understand that text book concepts do not always suit real life circumstance. However, I infer what we erroneously called accruals in that instance is prepaid expenses.
Cash basis accounting on the other hand, recognizes revenues and expenses when cash is paid and received. Cash basis accounting though acceptable for small business, medium to large companies are required to practice accrual basis accounting. The revenue and expense recognition principles are in line with accrual basis accounting as they recognize the period in which revenue is earned not when cash is received and period in which expense is incurred not paid respectively.
In order to effectively record revenues and expenses in the period which they are earned or incurred, it becomes imperative for companies to make adjusting entries. This is key because initial transaction data pulled together, that is, trial balance may be incomplete or not up to date. Adjusting entries can be broadly categorized as deferrals or accruals. While deferrals can be expenses paid in cash and recorded as assets before they are used, hitherto referred as prepaid expenses or unearned revenues being cash received and recorded as revenues before earned. Accruals on the other hand can be revenue earned but not yet received as cash or expense incurred but not yet paid. These are accrued revenues and accrued expenses respectively.
Thus every adjusting entry consist of an income statement account and a balance sheet account.
The concept of adjusting entries is indeed new to me, as I suppose it is handled by the finance team of the company I work with. However this topic in Corporate financial accounting helps me understand more clearly, reason the finance team periodically demands accruals from my team particularly at the end of the fiscal year. This topic is for me, is an eye-opener.
