What are Financial Accruals and Allocations, and Why Do They Matter?

What are Financial Accruals and Allocations, and Why Do They Matter?

At certain times every month, you know that your company’s controller is busy “closing the books.” To
those outside of the financial world, this can be a bit of a puzzle: why on earth does it take as long as it does?
You might think it should only take a day or two to add up all the end-of-the-month figures. But two or three

On the surface, it may seem that simple, but the reality is that there’s a lot more that goes into getting
those end-of-period numbers. One of the steps that a lot of time is figuring out something called accruals
and allocations.

Simply stated, accruals and allocations are used to try to create an accurate financial picture of the
business for the month. After all, it doesn’t help anybody if the financial reports don’t tell us how much it cost
us to produce the products and services we sold last month. However, determining accruals and allocations
nearly always entails making assumptions and estimates. Let’s look at an example to illustrate what these
estimates and assumptions might look like:

Let’s say you worked in June on a new product line at your company, and that new line was introduced
in July. Now the accountant determining the allocations must estimate how much of your salary should be matched to the product cost (because you spent much of your time on those initial products) and how much
should be charged to development costs (because you also worked on the original development of the
product). In addition, they must also decide how to allocate those costs to June versus July.
Depending on how they answer these questions, they can dramatically change the appearance of the
income statement. If they allocate more of your salary to product costs, product costs go up, making the
product seem less profitable. If they were to put more of your salary towards R&D, because of how R&D is
categorized on the financial statements, it doesn’t affect gross profit at all.

Now back to the example. Let’s say the accountant determined that all salaries should go into
development costs in June, rather than product cost in July. They assumed that your work wasn’t directly
related to the manufacturing of the product and therefore shouldn’t be categorized as product costs. But by
doing so, there’s a twofold bias that results:

First, development costs are higher than they otherwise would be. An executive who analyzes those
costs, later on, may decide that product development is too expensive and that the company shouldn’t take that
risk again. This might mean the company will do less product development, thereby jeopardizing its future.
Second, the product cost is smaller than it otherwise would be. That, in turn, will affect key decisions
such as pricing and hiring. Maybe the product will be priced too low or too many people will be hired to
produce the product even though the profit reflects some dubious assumptions.

While one salary may not make that big of a difference to a large product, if the assumptions are
applied to many people, the effects then become much more real. Because of the potentially crucial
implications of these decisions, it takes a lot more time and effort to “close the books” so that those reports
reflect the most accurate picture possible. This, in turn, helps those making decisions all throughout the
company make better, more accurate decisions.

Source: Financial Intelligence by Karen Berman, Joe Knight and John Case. Joe Knight, and his
partners, Joe Cornwell and Joe Van Den Berge from Setpoint Inc. together have built two
companies with a 25-year history of successfully implementing these principles in their thriving
businesses. Setpoint Inc. designs and implements custom rides and attractions for the top
amusement and theme parks in the world, and Setpoint Systems delivers custom automation
and robotics that helps manufacturers large and small improve the way they make and
distribute goods.

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