Accrual principle

Imagine a scheme that owes its auditor a fee but has not yet paid it. If it counted only cash that had actually left the bank, today's profit would look better than it is, and so would the NAV. Investors buying in today would overpay; those redeeming would take money that belongs to the investors who stay.

The accrual principle closes that door. The workbook puts it plainly: while calculating profits, all the expenses that relate to a period need to be considered, irrespective of whether or not the expense has been paid. The same applies to income — any income that relates to the period boosts profits whether or not it has reached the bank account.

So a dividend declared by a company the scheme holds, or interest earned on a bond since the last coupon, is counted as it accrues. A fee incurred is deducted as it accrues. Timing of cash is irrelevant; timing of the economic event is what counts.

In the NAV (Chapter 7, section 7.2.1). The workbook's scheme mobilised Rs 200 crore. It received Rs 8 crore of interest and dividend, paid Rs 4 crore of expenses, and has a further Rs 1 crore of expenses payable. Profit is taken as 8 − 4 − 1 = Rs 3 crore, not Rs 4 crore. With Rs 14 crore of appreciation, net assets are Rs 217 crore and NAV Rs 10.85. The alternative formula shows the payable explicitly: (Rs 218 crore of total assets − Rs 1 crore of liabilities) ÷ 20 crore units.

On the asset side, accrued income — dividend or interest due on securities held but not yet received — is part of total assets, alongside receivables such as amounts due on shares sold. Accrued expenses sit among the scheme's liabilities.

Every day, even on holidays. Liquid and overnight funds declare NAVs on Sundays and holidays too, and the workbook explains why: the NAV reflects the accrual for that day.

In distributable reserves (section 7.3). All profits computed on the accrual basis are treated as available for distribution, because accrued income is receivable and accrued expense payable — it is only a question of time. Valuation gains are different: they may never be realised, so they are ignored, while valuation losses must be adjusted.

Profit for the period
  = Income relating to the period (received + accrued)
  − Expenses relating to the period (paid + payable)

Accrued expense — the workbook's Rs 200 crore scheme.

Ignoring the unpaid Rs 1 crore would overstate NAV by 5 paise a unit.

Accrued income — the workbook's Example 1. Stocks Rs 150 crore, bonds Rs 67 crore, money market Rs 2.36 crore, dividend accrued Rs 1.09 crore, interest accrued Rs 2.68 crore, fees payable Rs 0.36 crore, units 1.90 crore:

NAV = (150 + 67 + 2.36 + 1.09 + 2.68 − 0.36) ÷ 1.90
    = 222.77 ÷ 1.90 = Rs 117.25

Leave out the two accruals (Rs 3.77 crore) and the scheme is undervalued:

(222.77 − 3.77) ÷ 1.90 = 219.00 ÷ 1.90 = Rs 115.26

An investor redeeming 1,000 units would be short-changed by (117.25 − 115.26) × 1,000 = Rs 1,990.

Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units) states the principle in section 7.2.1 using the Rs 200 crore illustration, applies it in Example 1, and returns to it in section 7.3 on distributable reserves. Chapter 5 links holiday NAVs of liquid and overnight funds to daily accrual. Expect NAV arithmetic in which an accrued item is dangled, and a conceptual question on why accrued income counts towards distributable reserves but valuation gains do not.

• Unpaid expenses are deducted; unreceived income is added. Both, not just one.
• A scheme cannot show better profits by delaying payments — the workbook's own sentence, and a favourite true/false.
• Accrual is not valuation. Accrued income is certain to arrive (a question of time); valuation gains may never be realised. That is why accrued profits are distributable and valuation gains are not.
• Valuation losses still reduce distributable reserves, even though valuation gains are ignored.
• Liquid and overnight funds declare NAV on Sundays and holidays because the day's accrual changes it.
• Not to be confused with an accrual strategy in debt funds (Chapter 10), which means focusing on interest income rather than capital gains.