You have just invested in a Bank FD which carries an interest rate of 10% per year, paid every quarter.
So, if you invested Rs. 10,000 in this FD, at 10% a year, you get Rs. 1,000 for a year. Since the interest is paid out every quarter or 3 months, you get Rs. 250 every quarter.
Now, what is the value of your investment at the end of Month 1, Month 2 and Month 3?
OK.
What if I say that at the end of Month 1, the value of your investment is Rs. 10,083.33, at the end of Month 2, it is 10,166.67 and at the end of month 3, it is Rs. 10,250.
You shake your head in disagreement.
“What nonsense is this? I am getting the interest only at the end of month 3, so why are you doing this trick?”
Well, it does look like a trick but a perfectly legal one.
What I did is widely known as Accrual.
The Accrual world
Accrual means you recognise your income and expenses when they become due and not necessarily when they are paid.
Let’s take another example. Suppose you take a loan from the bank where the interest is to be paid every year.
Would you not find it convenient to set aside some amount every day, every month or every quarter so that you have the money available to you when the time comes to pay?
When you do it, you accrue your interest payable, that is, provide for the interest to be paid it on a periodic basis.
The same is true of any income (interest, dividend, rental, etc.) or expense (electricity, wages, housekeeping, etc.)
World over, most businesses maintain their accounts with this principle in mind. It is one of the cornerstone principles of accounting.
The income is booked when it is earned and not when it is received. Similarly, expenses are recognised when they are incurred and not when they are paid.
Yes, welcome to the world of accounting!
The cruel part of Accrual
You know what concept do most businesses around the world use to artificially inflate their income/revenues and profit?
You guessed it. How do they do it?
Well, they show additional sales without receiving any cash (accrual at work). Hence revenue is inflated and resultantly, profits go up.
This is one of the dirtiest tricks used out there to overstate incomes and profits. In other words, if you want to cook the books, fall back on accrual.
Remember Enron!
Accrual is the difference
Question: Tell me, which internet company, in its over 2 decades of existence, has hardly reported any profits of significance, but its a serious cash generation machine?
I am sure by now you have understood that Accrual leads to the difference between profit and cash.
Now, when it comes to investing, what matters more – Profit or Cash?
To a real investor, cash is the thing that truly matters.
One of the most prominent valuation methods is called DCF or Discounting Cash Flow method. As per this method, present value of expected future cash flows is determined to know if a company is worthy investment proposition or not.
In contrast, P/E or the Price Earnings ratio is based on the Accrual concept. It relies on Earnings, a number derived from Accrual accounting.
So, while accrual determines what gets shown in the Profit & Loss Account, you have to go searching for the Cash Flow Statement.
The saying is, “Profit is vanity, Cash is sanity.”
Accrual and Mutual Funds
What’s accrual got to do with mutual funds? Actually quite a bit.
If you know, there are two investment management strategies used by debt fund managers.
- Income Accrual – conservative and steady, think ultra short term funds or FMPs.
- Duration management – aggressive and volatile, think gilt funds or dynamic bond funds.
In income accrual, the attempt is to identify short or medium term high yield bonds that will deliver low risk income. The gains are steady and less volatile. The idea is to cash in on the yields being offered without compromising on the credit quality.
From an accounting point of view, the funds investments are marked to market and that’s where the accrual concept comes to play its part. On a daily basis, the interest portion of the holdings is accrued to the fund and reflects in its NAV. (Remember the FD interest example from earlier in the post.)
We will cover more about debt funds and their strategies in a separate post.
Accrual of Knowledge
Knowledge too accrues, steadily over time. The actual pay off may happen much farther into the future. Let that not deter you from making that investment in knowledge.
As Benjamin Franklin said, “it pays the best interest.”
Between you and me: At some point I will ask you, “Have you accrued your interest?” Now, which is the company with loads of cash but hardly anything to show for profits?