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May 16, 2019

Using the Accrual Concept to Improve Financial Reporting – Part 2

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Back in December 2018, I discussed the concept of using Job Cost accrual entries to acknowledge the matching principle, one of the key tenents of GAAP (Generally Accepted Accounting Principles) accounting, to more accurately reflect Gross Margin on the Income Statement.  At the end of the discussion, I promoted the use of accrual entries to recognize the consumption of overhead expenses that are paid less frequently than monthly to accomplish the same objective.  Let’s examine that now.

The typical workflow for recognizing monthly overhead (or G&A – General and Administrative) expense is as follows:

  • DR       Expense                      XXXXX
  • CR        Cash                            XXXXX

            or

  • DR       Expense                      XXXXX
  • CR        Accounts Payable       XXXXX

            and then

  • DR       Accounts Payable       XXXXX
  • CR        Cash                            XXXXX

Now you need to record a large overhead expense, say, your property tax invoice, issued by your local municipality.  Typically, it is for a significant amount, say $120,000, and billed twice per year (in two $60,000 installments), in January and July.  If you use the aforementioned workflow to record this expense, and you compare your Income Statements on a monthly basis, you will see a significant fluctuation in the “bottom line” (Net Income) during the two months that are impacted by this entry.

To smooth out this expense over the course of the fiscal year, consider using a Prepaid Asset account and an Accrued Liability account to amortize this expense.

  1. Assuming a calendar fiscal year, record this entry in JANUARY:
  • DR       Prepaid Expenses (asset account on the Balance Sheet)                   $120,000.
  • CR        Accrued Liabilities (liability account on the Balance Sheet)              $120,000.

  1. EACH MONTH, from January through December, expense one twelfth (1/12) of this amount by amortizing the Prepaid asset accrual:
  • DR Property Tax Expense (G&A account on the Income Statement)            $10,000.
  • CR Prepaid Expenses                                                                               $10,000.

  1. Code for entry into Accounts Payable the actual invoice in January and July as follows:
  • DR Accrued Liabilities (NOT Property Tax Expense)                               $60,000.
  • CR Accounts Payable                                                                               $60,000.

  1. Pay the bill:
  • DR Accounts Payable                                                                               $60,000.
  • CR Cash                                                                                                    $60,000.

As you can see, your Income Statement is impacted by $10,000/month, EVERY MONTH, with entry #2.  By the end of the year, your Prepaid Asset and Accrued Liability accounts will be $0, via the monthly “write-off” of the prepaid and the twice/year vouchering of the tax bill (via entries #2 and #3, respectively).

In summary, use the accrual method (rather than the cash method) of accounting to more accurately reflect your company’s operations and financial strength.

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