What is accured revenue?
Accrued revenue is revenue for which customers have been billed but have not yet paid because the product or service being billed has already been delivered to the customer.
Accrued revenues are reported as receivables on the balance sheet, as a result proving the kind of money customers are owed for the merchandise or service offered.
Accrued revenue may use to compare with the realized or recognized revenue and other accrued expenses.
Key Takeaways
Accrued revenue applies in accrual accounting where revenues are taken at the point of sale, though payment is yet to be made.
This is in compliance with the revenue recognition rule, that dictate, revenues should be reported as they are earned.
Accrued revenue is posted using an adjusting entry that affects the items that, in case they would not feature on the financial statements when the period under consideration comes to an end.
It is particularly helpful in the context of contracts for service where contracts made may cover a number of accounting periods.
Understanding Accrued Revenue
Accrued revenue is an economic concept that has developed from accrual accounting and the revenue recognition and matching principles.
Revenue recognition principle involves reporting of revenue transactions when they occur in the course of the accounting period in which the revenue was earned rather than tallying it with the time when payment for the product or service was effected.
The matching concept is an accounting tactic that attempts to link revenue accrued in one period of time with the cost that has been incurred to obtain that revenue.
In accordance with GAAP rules, accrued revenue is reported when the party performing the obligation fulfills a performance obligation.
For instance revenue can be acknowledged when a sale is conducted and the client takes delivery of an item despite the fact that the client employed cash or credit to pay for the good.
Accrued revenue is also common to the financial statements of business organizations in the service industry because to record the revenue would be to recognize it only when work is completed, which may take several months, from issuing of invoice as in the manufacturing industry.
If accrued revenue was not used, both revenues and profit would be reported in a very irregular pattern, which would not portray a clear and hence useful picture of how valuable the business is.
For instance, a construction company construction will be involved in one contract for many months.
It should be account for a part of the revenues for the contract each month as the services is provided, as opposed to at the end of the contract period all the revenues are accounted for.
Recording Accrued Revenue
Accrued revenue is taken in the financial statements through an adjusting entry.
The accountant debits an asset account for accrued revenue, which is reversed with the amount of revenue collected; crediting accrued revenue.
Accrued revenue deals with items that would not normally feature in the general ledger by the end of the period.
When one of the companies makes an entry of accrued revenue, the other company makes an entry in the accrual expense, which is a liability on the balance sheet.
Accrued revenue is recognized in the initial stage at the time when the amount is credited to the income statement through revenue.
This amount is debited in the balance sheet by an associated accrued revenue account and credited in accounts receivable.
When a customer pays for the goods or services that he has received, the accountant records this as an amount of cash received by debiting the balance sheet account- cash and crediting the same amount to either accrued revenue account or accounts receivable account.
Advantages of Accrual Accounting
Provides a more accurate financial performance: This gives a better view of how well or otherwise a firm has performed in a given period, since all revenues and expenses are considered.
Enhances decision-making: In terms of decision-making accrual basis provides relevant and useful information about current financial position of an organization. That is because it enables managers to view their organizations’ financial operations more broadly, including even all of the revenues and expenses that may have been incurred or generated.
Better alignment with the matching principle: The accrual basis of accounting is a fall out of the matching concept that requires all revenues and expenses to be reported in the same period. This lets the managers to differentiate between the revenues and expenses of the business within a specific time frame which would help in budgeting and performance assessment….
Facilitates long-term planning: Accrual basis of accounting yields information that can be employed in planning over a long term. The data can then be processed and used to anticipate a certain cost or revenue that was experienced in earlier periods so as to come up with the following kind of pattern; the cost could be rising or falling.
Better compliance with accounting standards: The data presented above prove that accrual basis accounting is in accordance with Generally Accepted Accounting Principles (GAAP) as well as International Financial Reporting Standards (IFRS). It can be useful for firms when they have to submit financial statements with the special regulatory authority.
Disadvantages of Accrual Accounting
Complexity: Accrual basis accounting is generally regarded to be more complicated, and can be quite confusing without adequate training in accounting. The job involves knowledge of accounting standards and is characterized by precisely recording of transactions as soon as they occur.
Timing differences: Accrual basis accounting gives rise to a mismatch between when revenues and expenses are recorded and when cash comes in and goes out. Sometimes it can become challenging for managers to evaluate the actual financial performance of an organization at any given time.
Requires estimation: Accrual basis accounting involves many estimates, for example estimation of the number of bad debts or the life of fixed assets. It can give rise to error and imprecision where the estimates used are also imprecise.
Risk of misstatement: Accrual basis accounting exposes an entity’s financial records to omissions and even fraud due to the numerous accounting rules that are followed and the speed at which many transactions are executed.
Difficult to compare financial performance: The use of accrual basis accounting means that this kind of information is not readily commensurate between various organizations or across various time periods because of the differences in fundamental accounting concepts and techniques. This helps make a lot of difficulties for investors and analysts, to better and more accurately assess the financial position of a company.
How Accrual Accounting Works
The general idea of accrual accounting is that the accounts record a transaction when a good or service is delivered rather than when paid or received. The receivables list, debts and payments due are also made.
This method makes it possible to add the present and future cash receipts or payments to have an ideal picture of the firms present and future position. Accrual accounting is based on the matching concept whereby revenue and costs should be taken to the period in which they relate to. IFRS and GAAP have recommendations on accrual accounting.
It has, therefore, almost become the norm for companies across the world to practice accounting, excluding relatively small companies and individuals.
Accrual accounting qualification
Accrual accounting is mandatory for firms exceeding the $25 million in average gross receipt of revenues in the preceding three fiscal years.
In case a company failed to meet the above average revenue requirement it can choose between cash basis and accrual as its accounting method.
An accrual basis is obligatory for businesses that involve both, goods in stock and credit sales, irrespective of businesses’ sizes and revenues.
Benefits of Accrual Accounting
While the accrual method is less distorted about the current position of the company it has relative shortcomings because of the complexity that it has in comparison to the cash method.
This method developed from the realization that business transactions were becoming more complicated and that financial information need to be more accurate.
Store on credit, contingent assets that creates income for a long time changes the financial situation of a company at the time of stock.
Consequently, it is logical that such events should also be shown in the financial statements during the same reporting period as which these transactions take place.
Under accrual accounting, a firm receives quick information of expected cash inflows and outflows in business hence enables the management to make better use of current resources to prepare for the future use.
Accrual accounting vs Cash accounting
Accrual accounting give us value, which brings a better picture of a company financial position. However, most small businesses think cash accounting is best because it is not complicated.
These two used in preparing the income statement are – Accrual accounting – Cash accounting
Accrual accounting can be compared with cash accounting which recognizes transactions upon the occurrence of which involve cash transactions. Also, while engaging the accounts, cash basis and accrual differ in that:
Cash Basis of Accounting
This is because cash accounting employs the transactions that pay for goods that is undertakes. For instance, let’s imagine a consulting company that sold a $5,000 service to a client on the 30th of October for example. The client was given the bill for the services provided and he cash paid on the 25th of November. In a cash basis method, the consultant would recognize an amount of $5,000 due from the client as of Oct. 30, and $5,000 of revenue when received on Nov 25 and recorded.
FAQ’s
How can I explain accrual for people who are not in accounting or finance?
Accrual accounting utilizes the double entry accounting where payments or receipt enter two accounts when a transaction starts and not when it occurs.
What is a journal entry?
The accounting journal is the first record of assets, liabilities, debts, revenues, and expenses as they take place. An accrual, or journal entry, is made when a transaction takes place.
What are the three accounting methods?
The three accounting methods are, the cash basis of accounting, the accrual basis of accounting, and a combination of the two known as the modified cash basis of accounting.