Accruals are costs that you charge in your profit & loss account even though you may not have received an invoice for them yet in order to ensure that the expense is reflected in the relevant months they are due.

A typical example is your audit or accountancy fee you receive from your auditor or accountant. The auditor prepares accounts for 31st December 2006, but you don’t get billed until 2007 for the work. But the work relates to 2006 accounts, so we must make an estimate if we don’t know the exact amount for the accrual and put a charge into the 2006 accounts.

If your supplier is always late in sending purchase invoices to you, the purchase costs in your profit & loss account will be understated in one month and over stated when you receive the invoice in the next month. So we must accrue for the invoice not received yet. If we were sent 1000 widgets (that cost €1 each) in June, but did not get the invoice until July we must accrue for a cost (the invoice not received) of €1,000, otherwise we will have stock worth €1,000 and no cost for them.

Sales 22,000 11,000 widgets x €2
Purchases 11,000 12,000 widgets x €1
Less closing stock -1,000 1,000 widgets x €1
Cost of Sales 10,000
Profit 12,000
Sales Margin 54.45% 12,000/22,000
Mark up 120% 12,000/10,000

So in this example we have a purchases value of only €11,000 but we received 12,000 widgets. Our purchases are understated by €1,000 and our profit is overstated by €1,000. Our Sales Margin is wrong and our Markup is wrong

So how do we fix this using an accrual?

Sales 22,000 11,000 widgets x €2
Purchases 11,000 12,000 widgets x €1
Purchases Accrual 1,000
Total Purchases 12,000
Less closing stock -1,000 1,000 widgets x €1
Cost of Sales 11,000
Profit 11,000
Sales Margin 50% 11,000/22,000
Mark up 100% 11,000/11,000
Now our Profit & Loss a/c is correct. Our margins and markup are as expected

So accruals are used to match costs with sales. The goods sold in the month are matched to the costs for that month, with any missing costs being accrued for.

What about next month?

When the invoice comes in for the goods next month we will take into account that there was an accrual and ensure that the accrual is matched against the invoice so it is not double counted.