Page 48 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 3: Financing of Working Capital Needs

The above discussion on trade credit reveals two things. One, cost of trade credit is very-high Notes
beyond the cash discount period, company should not have cash discount for prompt payment
and Second, if the company is not able to avail cash discount it should pay only at the end of last
day of credit period, even if it can delay by one or two days, it does not affect the credit standing.

3.1.5 Accrued Expenses

Accrued expenses are those expenses which the company owes to the other persons or
organisations, but not yet due and not yet paid the amount. In other words, accruals represent a
liability that a firm has to pay for the services or goods, which it has already received. It is
spontaneous and interest-free sources of financing.

Example: 1. Interest that has accrued on an outstanding note that has not been paid
and taxes that have accrued but not yet been paid. Interest is paid
periodically in the year but the funds are used continuously by a firm.
2. Salaries, wages, interest and taxes are the major constituents of accruals.
Salaries and wages are usually paid on monthly and weekly basis
respectively. The amounts of salaries and wages have owed but not yet
paid and shown them as accrued salaries and wages on the balance sheet
at the end of financial year. Longer the time lag in payment of these
expenses, the greater is the amount of funds provided by the employees.
3. Similarly, tax is another accrual, as source of short-term finance. Tax
will be paid on earnings. Income tax is paid to the government on
quarterly basis and some other taxes may be payable half-yearly or
annually. Amount of taxes due as on the date of the balance sheet but not
paid till then and they are showed as accrued taxes on the balance sheet.

Notes All other such items of expenses can be used as a source of short-term finance but
shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity
expands, accruals increase, they automatically act as a source of finance, and Accruals are treated
as “cost free” source or finance, since it does not involve any payment of interest. But in actual
terms, it may not be true, since payment of salaries and wages is determined by provisions of
law and industry practice, similarly, tax payment governed by laws and delay in payment of tax
leads to pay penalty. Hence, a firm must be noted that use of accruals as a source of working
capital or it may not be possible to delay in payment of these items of expenses.

Importance of Accrued Expenses

The goal of every accountant is to present fairly the financial statements of the business. If there
are expenses that have been occurred and they are not reflected at period end, the statements
will not be accurate.
Management, outside investors and regulators depend on the accuracy of statements in order to
make decisions. In the case above, if management is unaware that the consulting expense is not
included, they may make incorrect decisions on how much money they have to spend on
supplies, or maybe bonuses.

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