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May 2 2019 - San Francisco, CA

Accruals: Michael Tannenbaum

Chris Read:
Welcome to another episode of Brex in the Black - where we discuss financial operations. We've got our CFO here, Michael Tannenbaum, to talk about accruals today. Michael, thanks so much.
Michael Tannenbaum:
Thank you. Accruals - a tricky one.
Chris Read:
Yes, a tricky one. So what are accruals? And why are they important for startups?
Michael Tannenbaum:
So accruals for anyone who's taken an accounting class, they usually start with cash accounting versus accrual accounting, right? This concept of accrual accounting is the idea that your books and records are supposed to represent activity that has been incurred, not necessarily cash that has gone out the door. So a really clear example of this would be if you pay - if you have employees who have worked up through Friday of the week, but the payday is the following Friday, they've already performed services, you owe them this money. It's cash out the door in the future, but you haven't paid them yet. So if the financial period that you're looking at is end of this Friday, do you say, oh, we haven't paid these employees yet, so we're not going to cost ourselves for that compensation? Or do you say we have an accrual? Does that make sense?
Chris Read:
Yes. So what's tricky or important about this?
Michael Tannenbaum:
Well, what's tricky or important about this is that most early stage companies are managing their accounting to cash. Right? Most people, if you're just running a small company, you don't know what you're doing - your two kids from Stanford, you don't have a CFO, you don't know what you're doing. You're usually managing to the bank account, you're saying, well, what do we spend this month? What did we spend last month. But as your company gets more sophisticated, you start to have accrual rules, both in terms of revenue, and in terms of expenses. What needs to happen is at least once a month, say any accounting period, you have to look and say well, what are the income and accrued expenses as of this date that aren't reflected in our cash position.

So for example, if you're a software business, you could have signed - you could have people who have started using your product, but they haven't been billed for their first month, but they owe some portion of their bill for using your product for part of the month - their statement hasn't come due yet, but you would recognize a revenue accrual. So you can say, well, of our customers that have started using product, they owe us this money. We haven't built them for it yet. So we do not have the cash but this is revenue we earned in this period, likely this month. And that's relevant, because the whole thing with accounting is you're always going to be looking at it for a certain period. The standard period as monthly. And so typically, each month you're doing these accrual estimates of revenue.

And now I'll go through some costs. We already talked about payroll, that's an obvious one. Often it's very infrequent that the payday and the month end date align. And so you're almost always going to have people who have worked and earned compensation that has not been paid, that will be accrued, that's an accrued expense. Another example of accrued expense would be legal services, you could have had a law firm working for 30 hours helping you through some regulatory issue, and those services have been performed. You owe that money. It happened in this month, and just because the law firm hasn't billed you doesn't mean you don't recognize the expense in this month. That is the essence of accruals.

There's a little bit more detail to it in the sense of what is actually happening for accounting with accruals? So for those of you who are not interested, turn off now.

But I will talk a little bit about what the accounting is. Right. And so the point is, when you have accrual revenue - but let's talk about it and expenses, it’s easier. And so this compensation, what you're doing is you are creating both an expense and a liability at the month end. So you're saying I have incurred this expense, but I haven't paid the cash, so I owe this to employees. So it creates a liability. So at the end of the month, on your balance sheet you would have an accrued liability for the wages that you owe employees that you haven't paid, and the offsetting entry would be the expense that hits your income statement. When you go and actually pay that bill - when you pay the employees - you then reverse the liability, you decrease it and you decrease cash, but your income statement is unaffected. You’ve already taking the expense. So the point is you look at the income statement and those services were performed in the last month - the fact that you pay the cash in the next month is the cash point. So it's just a switch on the balance sheet from liability to cash. It's a reduction in both liability and cash. Versus previously it was a hit to the income statement and an increase to liability.

So the point is that the income statement - you don't care when the company paid. I mean you do for separate purposes. But for the purposes of the health of the financial operations of that business, you only want to focus on when was the service or the revenue incurred? When was the expenses incurred? When was the revenue earned? That is the basis of accrual based accounting.
Chris Read:
All right. Michael, thanks so much for coming on to talk about accruals.
Michael Tannenbaum:
Thank you.
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