Q10: What is accrual accounting?

A:

Firms can last many years. For example, Wesfarmers has a market capitalisation of about $45 billion and is the largest company in Australia by revenue (about $68 billion) and the largest private employer in Australia with over 200,000 employees. It can trace its history to 1914 (more than 100 years ago), when it started as a co-operative providing services and merchandise to Western Australia farmers. It was listed on the Australian Securities Exchange in 1984 and has grown into a major retail and industrial conglomerate. Since firms can last for many years, they typically report periodically on their performance. This is because we do not usually want to wait until a firm completes its lifespan before we find out how it is performing. In the case of some firms, like Wesfarmers, that corporate lifespan might be very long; indeed, it might be longer than we as individual equity investors could expect to live.

Various people with genuine interests in a firm want to know what is happening to a firm at regular intervals during its life. To do this, financial statements are prepared using accrual accounting rather than cash accounting. Accrual accounting requires the matching of expected costs and benefits of economic activities in a period, regardless of whether there has been actual receipt or payment of cash. Cash is a hard concept. You either have the cash in your pocket from, or have handed over your cash to, another party; or you have not. There is not too much you can argue about that. On the other hand, accrual accounting requires us to assess the economic consequences of current business activity, which will be subjective and will necessarily mean we need to make assumptions and judgements.  Our assessment of the economic consequences of our business activity may be wrong, either deliberately or unknowingly. It is because we want to know about changes in value in our firm more frequently than simply once at the end of the full life of a firm, that we need to allocate or place our firm’s revenue and expenses into periods, which is necessarily based on making some judgements.