Welcome to Part 10 of Mining Man’s Mining Financial Basics series (click here for the full series).  This week we are looking at a complex accounting principle which is quite commonly encountered by non-financial people at mining operations and projects – accruals.

Accruals are an accounting instrument used to manage profits and losses from one month to the next.  Essentially accruals are used to manage the timing difference between when work is actually completed and when cash is received or paid for that work.
 

Income/Expenses VS Cash Costs

The key accounting concept behind accruals is that profits and losses are not actually recognised by a company at the same time as the cash changes hands.  The two things are considered separately.

Profits and losses of a business are a result of the “income” and “expenses” of that business.  The terms income and expenses mean exactly what you expect (money in and money out), but they are quite specific terms in finance that relate to when you’ve really earned or spent the money, rather than when the cash changes hands.

Accounting standards require that a business’ books and their profit statements are based on income and expenses being recognised in the period in which they occur.  This means we can’t wait until something has been actually paid for to declare it in our accounts.  We must declare it at the time the expense or income is incurred, not at the time when the cash changes hands.

For example:

If the mine needs to buy a pallet of oil, they will place an order for the oil and soon enough it will be delivered to site.  The mine doesn’t pay or transfer the cash to the supplier at the exact same time that the oil was delivered.  Instead, the supplier will deliver the oil then later on send an invoice through which tells the mine how much they need to pay.  At some later time (anywhere from a week to three months later), the cash will actually be transferred from the mine’s bank account to the supplier’s.

When the oil was delivered to the site, the mine incurred an “expense”, since they were now liable to pay.  Likewise, the supplier has at the exact same time made the “income” as far as the accountants are concerned, as they had delivered the product to the customer (even though they don’t have the cash yet).

 

The time when we receive or pay cash for something will vary depending on the terms agreed with the other party, their method of payment, and whether they will pay at all.  Profits and losses, in the form of income and expenses, and the transferring of cash very rarely occur at the same time.

The finance and accounting parts of the mine are mainly interested in income and expenses rather than the cash transfer side.  Their books need to be aligned with when the income or expense happens, not when the cash is paid.

In this article we’ll mainly discuss expenses rather than income, as that’s what operational managers mostly need to deal with.

Defining when Income or an Expense Occurs

It is pretty easy to identify the exact day on which the cash transfer for a particular transaction takes place – we can just look at the bank statements.  It is harder however, to determine exactly when an income was received or an expense incurred.  In our example above, it’s not too bad, we can record the expense as being on the day when the oil was delivered, and our stores system should automatically tell accounts when this was. 

But what about in the case of labour hire through a contractor?  The contractor might be working at site all month, so the mine is incurring expenses which will eventually need to be paid, but how does the accounting department know that these expenses have been incurred?  If they wait until the contractor invoices us early next month, it’s too late as the books for the current month are already closed. 

Sure, a purchase order might have been raised for the month, but again how does accounts know exactly how many hours were worked and therefore how much expense the company has been committed too?

Or what about for electricity use or phone bills?  We obviously use these all month and hence are incurring expenses for them, but we won’t get the bills/invoices to pay until next month.  It would be wrong for us to not book any phone expenses in the current month just because we hadn’t got the bill yet. 

The answer to these types of situations, is that the person managing the job or purchase order needs to tell the accounting department each month what expenses were incurred that haven’t yet been invoiced or paid for.  This is what accruals are about.

To summarise it in a sentence: Accruals are expenses place into the accounts of the current period for which invoices have not been received during this period.

The Accrual Process

Basically all accruals are about is making sure that expenses line up with the month in which they were incurred, rather than the month in which the invoice came and we paid for them. 

In a world where things were paid for as soon as they were used, we wouldn’t need accruals.  And in fact, this is really how our personal lives work, we usually pay for everything at the time we use or purchase it.  We don’t get to have a hair cut and then wait to get the invoice and pay for it next month!  The exception in our personal lives is bills – electricity, gas, water, phone – we don’t pay for these things until much later than we’ve actually used them.

For managers and other people who look after costs in the mining industry (or any industry for that matter), our role in the accruals process is to tell the accounts department what expenses we’ve incurred in the current month.  Different sites and businesses will have different methods for doing this, maybe using a spreadsheet or a review at a designated meeting at the end of each month. 

The usual starting point is that you’ll be presented with a list of all the purchase orders you’ve raised that still have amounts to be paid against them.  You’ll probably be asked to mark against each one what percentage of them was used this month, or what dollar amount has been used this month.
 

The Accounting Side

Now here’s where things get a little more complex - I’ll try to explain what actually happens on the accounting side of accruals (feel free to skip it if gets too much!).

The basis for accruals is an accounting principle called the matching principle (also called the Accrual principle).  One part of this principle tells us that we need to book down expenses and incomes in the period in which they occur rather than when the cash is paid or received, as discussed above.  It’s against the law for companies not to follow this principle.

Now the extra complexity is that all companies actually maintain two different types of records – the Profit and Loss statements, and the Balance Sheet.  Put simply, Profit and Loss Statements (P&L) records all the incomes and expenses, whereas the Balance Sheet records cash movements and balances.  Because of these two systems (which work together at all times), all accounting transactions always involve two entries somewhere in the company’s accounts.  This is the concept of everything balancing.

And so it is with accruals, there are two entries made.

The first entry is the one described earlier, where we book down an expense in the current month for any expenses we’ve incurred.  But what we now need to do is make sure that when the invoice for that work comes in next month, that we don’t double count it.  To do that, we put a negative expense into the accounts for next month.  Now when that invoice does arrive, and the accounts see it as a cost, it is balanced out by the negative cost that we already had in there.

These “negative expenses” can be confusing when you see them on your cost statements for the month.  The accounting term for them is “reversing the accrual”, as they are only there to make sure there is a balance with the “positive expense” entered in the month before.

An example might help.
 

Example – Contractor Labour

At the start of September I raise a purchase order for a contractor to do work at the mine all the way through September.  The total cost expected for the month is $20,000.  In the last week of the month I receive my accruals sheet to update.  Due to a delay, the work started two weeks later than what I was expecting, so in September there’s only going to be $10,000 worth of work done, and the rest will be done in October.  On my accruals sheet next to this order number, I’ll write down that $10,000 worth of work was done in September (or mark it as 50% complete depending on the site system).

The site accountant takes my accruals sheet and uses that to enter an expense of $10,000 for September.  They then put a negative expenses (i.e. -$10,000) in October.

During October, the work is all complete, comes in right on budget, and the invoice is received and paid.  When I get my cost report for the month, I’ll now see that the $20,000 invoice came in and was paid, and then the -$10,000 expense was also applied to this, leaving a total of $10,000 of expense in October.  Which is exactly what I want because that’s how much work was done in October!

So what we’ve done is made sure that although we paid $20,000 in cash to the contractor in October, we spread the expense to the company over September and October in line with when the work was actually completed.   

   

Important note: different mines will have different ways in which they wish to treat accruals of certain items.  In most cases items which are purchased as a once off and delivered don’t need to be accrued as they are invoiced and paid for straight away.  Sometimes they’ll need accruing if the invoices haven’t arrived.  The most common items which need accruals processed are services or constant supply items such as labour, electricity, royalties etc (things you get billed for quite a while after you got the benefit from them).

Summary

Accruals can be a confusing concept for us non-financial people to get our heads around, particularly when the site finance manager turns up at our door in the last week of each month wanting us to fill out an accruals spreadsheet by the end of the day, or gives us our department’s cost report and there’s all these negative costs in there that look like we’re making some profit!!

In the end, the accounting side of accruals and reversing accruals is quite complicated, but the inputs required from operational managers is not too difficult.  Basically all that is required is for you to say how much of a particular job or purchase order has been completed in this month and estimate how much we’re going to have to pay for it.

This has been a fairly simplified view of accruals, designed only to explain the process in broad detail.  I’d love to hear your feedback or any corrections in the comments section below.

   

Next week, in the final part of the series (click here to see the full series), we'll cover a full list of other common financial terms you might hear, with short definitions and examples.  CLICK HERE TO MOVE ON TO THE NEXT PART OF THE SERIES.

Have a safe and (financially) productive week!

- Jamie Ross

Mining Man - Great Safety, Leadership and Productivity Ideas for the Mining Industry


 

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