Estimated reading time: 3 minutes
This post will focus on the accrual principle, which is really the fundamental idea behind how accounting works.
Have you ever wondered what accountants do? And why they are needed? In this day-and-age with such sophisticated technology at our disposal, why is it necessary to employ accountants to obtain financial results? Shouldn't the results just be available at the click of a button?
We will look at the role and duties of a finance manager in another post, but for now let's focus on why accountants are needed to prepare financial results.
If accounting were based simply on actual monetary transactions, then obtaining the month's or year's financial results would be as simple as logging onto the business' internet banking. The increase or decrease in the amount of money in the bank account over the relevant period would be the profit or loss for that period.
The reason that accounting is more complex is because it is not simply counting money. Instead it requires a combination of judgement and estimation due to the accrual principle. The accrual principle states that:
“Accountants should record transactions in the periods to which they relate, rather than just when the cashflows from the transactions occur.”
So practically speaking what does this mean, and how does it work?
Imagine you run a business that grows delicious oranges in Florida. You sell these oranges directly to a supermarket chain, and to do so you deliver the oranges to the supermarket's warehouse.
Each time you deliver a shipment of oranges, your finance department issues an invoice to the supermarket. The supermarket will hopefully pay this invoice after the agreed credit period, which is often about 30 days (but could be much longer).
In this example, there are 2 accounting transactions that your finance staff would record. The first is the sale of oranges, which is deemed to take place when you deliver the oranges and the supermarket accepts and takes possession of them. No money has changed hands yet, but the supermarket is legally obliged to pay your invoice and your business could sue the supermarket if it doesn't.
The second transaction is the actual monetary one and occurs when the supermarket pays the invoice. This is called a cash receipt.
Modern accounting is called accrual accounting because it is based on the accrual principle. This means that both monetary transactions (such as cash receipts) and non-monetary transactions (such as revenue) have to be recorded.
Hopefully you can see the main advantage of accrual accounting compared to simple cash accounting which only looks at money in and out. Accrual accounting more accurately reflects the company's operating reality. If the supermarket has bought your oranges then it has to pay for them. You've delivered the oranges, you can't sell them to anyone else, you no longer own them and so your accounts should reflect that a sale has been made.
What about the disadvantages? Well for a start accrual accounting is more complex and involves more work - as we have seen it's one of the reasons that accountants are required. Another important consequence is that with accrual accounting we leave the simple world of actual money behind and focus instead on "revenue" and "profit". Neither of these have an actual physical reality - they are just accounting estimates. And because of this they are open to manipulation. Virtually every corporate scandal - such as the collapse of Enron and more recently Tesco's accounting scandal - has at its root this separation of profit and cashflow which results from the accrual principle.
So while the accrual principle is a key foundation on which accounting is built, the benefits it brings certainly comes at a price.
If you'd like to find out exactly how profit and cashflow are linked, and learn more about the accrual principle and its consequences, take our free online Basic Accounting course.