Why are Accruals Needed Every Month
Accrual accounting is a method that records financial transactions when they are incurred, rather than when cash is exchanged. This approach provides a more accurate picture of a company’s financial health by recognizing revenues and expenses as they are earned or incurred, rather than when payment is received or made. Monthly accruals are necessary for several reasons:
Why Monthly Accruals Are Needed
- Financial Reporting Accuracy: Accurate monthly financial statements are essential for management to make informed decisions. Accruals help ensure that revenue and expenses are recorded in the period they relate to, not just when cash changes hands.
- Budgeting and Forecasting: Monthly accruals make it easier to compare actual performance against budgets and forecasts. This aids in future planning and adjustments to business strategies.
- Cash Flow Management: Understanding accrued expenses and revenues helps management to better understand the company’s cash position, even if payment has not yet been received or made.
- Regulatory Compliance: Accurate financial reporting is not just good business practice; it’s often a legal requirement. Publicly traded companies, for example, are required to comply with generally accepted accounting principles (GAAP), which mandate the use of accrual accounting.
- Investor and Stakeholder Confidence: Accurate and timely financial statements can impact a company’s stock price and access to capital. Investors and lenders rely on financial statements to assess the health and profitability of a business.
- Performance Metrics: Accruals contribute to key performance indicators and financial ratios that stakeholders use to evaluate a company’s performance over a specific period.
- Operational Efficiency: Monthly accruals help in identifying unprofitable products or services quickly, allowing for operational changes to be made in a timely manner.
Example of Why are Accruals Needed Every Month
Let’s consider a concrete example to illustrate the importance of monthly accruals using a fictional company, “CleanCo,” that provides cleaning services to corporate clients.
CleanCo provides a monthly cleaning service to its client, “OfficeCorp,” for $2,000 per month. However, CleanCo invoices its clients quarterly, which means it only sends an invoice of $6,000 at the end of every three months.
Without Monthly Accruals:
If CleanCo didn’t do monthly accruals and only recorded revenue when the invoice was paid, its financial statements would show a misleading picture. For two months, it would appear as if the company made no revenue, and in the third month, there would be a sudden spike of $6,000. This does not accurately reflect the company’s ongoing operations and can lead to poor decision-making.
With Monthly Accruals:
By using accrual accounting, CleanCo can recognize $2,000 in revenue every month, even though it hasn’t yet invoiced OfficeCorp. This presents a more accurate view of the company’s financial health and ongoing operations.
Journal Entries for Monthly Accrual:
At the end of each month, CleanCo would make the following journal entries:
- Debit Accounts Receivable $2,000
- Credit Revenue $2,000
These entries recognize that CleanCo has earned revenue by providing services, even though it hasn’t yet received payment.
Reversing the Accrual:
When CleanCo eventually invoices OfficeCorp and receives the $6,000 payment at the end of the quarter, it would reverse the accruals and recognize the cash receipt as follows:
- Debit Cash $6,000
- Credit Accounts Receivable $6,000
Why This Matters:
- Accurate Financial Reporting: By accruing $2,000 in revenue each month, CleanCo’s financial statements reflect its consistent level of business activity, which is crucial for internal decision-making and external reporting.
- Cash Flow Management: The monthly accruals allow CleanCo to better anticipate when it will actually receive cash, aiding in cash flow management.
- Budgeting and Planning: By recognizing revenue as it is earned, CleanCo can more accurately measure its performance against its budgets and forecasts.
- Investor Relations: Accurate financial statements are important for maintaining investor confidence. If investors only saw revenue every three months, they might become concerned during the “dry” months.
By using monthly accruals, CleanCo ensures that its financial statements accurately reflect its business activities, which is critical for effective management, planning, and investor relations.
