Accruals and Deferrals (#172)
/In this podcast episode, we discuss the use of accruals and deferrals. Key points made are noted below.
The Use of Accruals
An accrual is a journal entry used to recognize an expense or revenue item in the current period, while a deferral is a journal entry that pushes out recognition to a later period. I already talked about this somewhat in Episode 21, which was about streamlining the use of journal entries so that you can close the books faster. My main points were to avoid immaterial journal entries, use a standard set of journal entries, and use standard templates when making entries. And that’s a good start. I’d like to flesh out the topic with some additional points.
Accruals and Deferrals for Revenue
My first point is how to deal with accruals and deferrals that involve revenue. This is a really sensitive topic with auditors, especially when you’re moving around revenue numbers right at the end of the year, when they impact the annual financial statements. Two suggestions here. First, if you’re going to take an action that will increase the reported amount of revenue, think long and hard about it before doing so, because you’re absolutely going to be investigated by the auditors. And second, document the entry to death, with detailed justification for why you increased the revenue figure. When in doubt, don’t do it.
Now, what about the reverse concept with revenue, where you elect to defer revenue recognition into a later period? This is nice and conservative. But – the situation usually arises when the company receives an advance payment from a customer, where the entry is a debit to cash and a credit to a liability account. If you make this entry, will the amount of the liability trigger a covenant breach on any loan agreements? If so, you might want to make management aware of the situation.
Accruals and Deferrals for Expenses
Now let’s switch over to expenses.
First up is compensation expense. If there’re a lot of hourly employees, it’s likely that you’ll have to accrue a large expense for unpaid wages at the end of each month. Depending on the number of these employees, compensation expense may be the largest accrual entry, month after month. Since it’s the biggest, it’s the most likely to be audited – in detail.
And that means you’ll need to be extra careful with the entry. The issue most likely to be screwed up is what’s not in the entry – which is payroll taxes. In many cases, the accounting staff only thinks about the unpaid wage figure itself, and forgets to accrue for any payroll expense. So have a standard calculation spreadsheet, and make sure there’s a built-in formula that includes payroll expense.
Another problem with accruing unpaid wages is the nature of the supporting spreadsheet. It may contain a listing of each hourly employee, and you then add in the hours that each person worked that were unpaid. The trouble is, you have to remember to add to the spreadsheet any new employees – which is easy to forget. One possibility is to note on the spreadsheet a reminder to add new staff. Or, avoid the whole problem by having the payroll system automatically generate the cost of the accrual.
A topic related to compensation is the accrual of vacation time. The standard approach is to set up a spreadsheet that lists the unused vacation time of each employee, multiplied by their hourly wage rate. The total is the vacation accrual. There’re three problems with it. First, you need to add a payroll expense accrual; otherwise, the expense is under-reported. Second, put a note in the month-end closing procedure to check for pay raises. If anyone received a raise, transfer that amount into the spreadsheet, so the total vacation expense is increased.
And third, there’s the issue of use it or lose it vacation time. Under this concept, a company terminates any accrued vacation time if employees haven’t used it by the end of the year. In a fair number of cases, they allow employees to transfer a small number of hours forward into the next year, but not the full amount. If you have this rule in place, the goal is to ensure that there’s a correct vacation accrual at the end of the year, when the books are audited. That means there’s an upper boundary on the amount of the vacation accrual in the preceding months, which is the maximum number of hours that can be rolled forward into the next year.
If you don’t use this cap in the calculations, you end up with this wildly fluctuating vacation accrual in the preceding months that’s really high in some months when everyone is earning vacation but not using it, and dropping catastrophically, usually in the summer, when everyone uses it.
Now, if compensation expense isn’t the biggest accrual, it’s likely that the largest one is going to be accruals for supplier invoices that haven’t arrived yet. This is usually a cost of goods sold item, and it can be a hefty accrual, especially if the company is closing the books fast, and isn’t waiting for late invoices to arrive.
I can’t emphasize enough just how easy it is to screw up this accrual. There needs to be a good system in place for figuring out which invoices haven’t yet arrived, which needs to encompass both goods and services. That’s hard for services, since you can’t find the information in the receiving log. And in addition, this accrual has got to be automatically reversing. Otherwise, the expense sits on the books until someone decides to reconcile the balance sheet accounts, which may not happen for months.
So how do we make the supplier invoices accrual work? At the simplest level, if you keep running into late supplier invoices that aren’t included in the correct reporting period, and these amounts are material, then you’re just going to have to extend the closing period – maybe for a week or more, until all of these invoices arrive.
Long term, the solution is to figure out which suppliers submit invoices late, and then work through a procedure for estimating the amount of each of these invoices in advance. The result may be five or ten – or more – different estimation calculations. It’s pretty much going to be a case of how much work do you want to go through to estimate supplier invoices, versus the benefit of closing the books faster. It’s your call.
Here’s another accrual that causes trouble – employee benefits. We’re talking about medical insurance, life insurance, dental, disability, and so on. Insurers want to be paid before the period to which the insurance applies. That means the company has to defer recognition of these payments until the following month, so the initial entry is a debit to a prepaid expense account.
Deferring an expense is a little unusual, at least in comparison to the bulk of the journal entries made, so the accounting staff is more likely to get it wrong – and this is a problem, since the benefits expense can be a large number. To get it right, set the default expense account for all benefits suppliers to the prepaid expenses asset account. That means the initial recordation is not to an expense.
Then, when it’s time to close the books, have a specific closing step that requires someone to examine the prepaid expenses account to make sure that the correct benefits amount has been moved to the benefits expense. And on top of that, have a specific review step for the accounting staff, where they check the contents of the benefits expense account in the preliminary income statement, just to make sure that the correct expense amount was recognized. This is a bit of a pain, but if you don’t do it, there’ll undoubtedly be times when there’s no benefits expense recognized in one month, and double the amount in the next month.
And a final comment on accruals is not to wait until the end of the year to recognize depreciation expense. If you do that, there’s a massive lump of expense at the end of the year that may offset a lot of what might have looked like a pretty good year-to-date profit. It’s better to manage the expectations of company management by including a portion of the depreciation expense in each successive monthly income statement, so there’re no surprises at the end of the year.