Accrual and depreciation demystified

These two fundamental accounting concepts can be difficult to conceptualise. But if they are understood as ‘non-cash items’, they make far more sense.

Accrual and depreciation demystified
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Before I began my personal journey towards financial literacy, I always assumed that ‘profit’ was straightforward – more money came in than went out. It seems so obvious, doesn’t it?

READ:Confusing credits and creditors

But it’s completely wrong!

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In trying to explain this to me, Ronnie, my financial literacy teacher, used two words – ‘accrual’ and ‘depreciation’. They refer to costs or revenue that are on paper only. Ronnie called them ‘non-cash items’, and the penny finally dropped!

Let’s take the example of fertiliser purchased in September on a 90-day credit term. Payment is due in December, but we have to recognise that a purchase has occurred – accrued – and must be included in the September accounts.

Just because you’re paying in December, it doesn’t mean you don’t have the goods! Even if the supplier didn’t send an invoice with the goods, a ‘goods received’ note should have been completed. This ‘recognises’ the transaction and brings it into the accounts.

As a non-cash item, it has no effect on the cash reserves of the business, but it is a cost, and must be accounted for.

So, even though it is not yet paid for, it reduces the profit in September. The cash flow will be affected only when payment takes place.

The same often occurs with revenue. Take a fixed price sale of an export consignment of citrus in June with payment due in August.

In this case, if we accrue the revenue from this sale on the day of dispatch, the accounts for June will show a good ‘profit’. However if, the buyer cannot pay, it has been a fiction all along.

If the money cannot be recovered, a ‘bad debt’ will have to be recognised. This will wipe out the ‘profit’ reflected in the books.

While discussing the pitfalls of accrual, I learnt that it is always prudent to ‘recognise’ a purchase transaction such as the fertiliser mentioned above – but unless a sale transaction is a certainty, it’s irresponsible to recognise it in the books.

As you’ll appreciate, the accrual concept – bringing costs and revenues to account before they actually happen – opens up room for errors of judgment or potential manipulation of reported profits.

Hence the well-known maxim among accountants that ‘cash is a fact, profit an opinion’.

Another non-cash cost item that appears on all financial accounts is the little understood ‘depreciation’. While late payment for fertiliser or delayed receipt for delivery of export citrus are tangible items, depreciation is an invisible cost that creeps up over time.

Every piece of machinery has a finite economic life, and will need to be replaced. Depreciation is the theoretical non-cash cost charged to the business for this replacement.

This annual depreciation amount should be placed in an account safely out of daily reach, until you need to buy that replacement tractor. As a cost, it reduces profit, but unless it is spent, it has no effect on the cash flow.

This leads me to one calculation that used to mystify me completely – the adding back of depreciation to profit to determine cash flow. Ronnie drew up a table (Table 1), and a careful perusal of it demystified the subject completely.

Does it do the same for you?

Once I appreciated that profit statements reflect cash and non-cash costs, I thought

I was well on the way to financial literacy, but I still had a few rude shocks in store, involving things like ‘goodwill’, ‘current ratio’ and ‘headline’ and ‘marginal’ costs.