The accrual-based accounting system implies that the revenues and expenses should be recorded when they are earned or incurred. This accounting approach does not relate receipt or payment of cash with the recognition of the economic transaction.
The accrual-based accounting system is based on the matching principle of accounting. The matching principle is one of the basic accounting principles implying that the economic events and financial transactions should be recorded when the actual transaction occurs regardless of when the cash is paid or collected.
When a business entity uses the accrual-based accounting system, the accrual accounts are created in the accounting books to record the economic transactions such as credit sales, credit purchases, salaries payables, outstanding creditors, etc. The four common types of accruals are unearned revenues, accrued revenues, accrued expenses, prepaid expenses.
In this article, we will discuss the accrued revenues recorded in the accounting books of business entities and how to account for the accrued revenues. So, let’s get into it.
What are accrued revenues?
Accrued revenues are defined as,
The revenues that the company has earned by providing the services or the goods to the customers. However, the payment for the revenues has not been received by the business entity.
When the services or goods are delivered before receiving the payment, the revenues become accrued and remain there until the client makes the payment.
The accrued revenues are based on the matching principle of accounting that implies the application of an accrual-based accounting system. However, there is another accounting principle that dictates the recording of accrued revenues.
The revenue recognition principle implies that the revenues earned in a financial period should be recorded in the same period and not after.
From this accounting principle, we understand that the companies should record their revenues when the services are provided and not when the cash is received. It is also important to use accrued revenues because it is impossible to operate your business on a cash basis in today’s complex business structure.
What type of businesses record accrued revenues?
Although most of the business entities use the accrual-based accounting system for the preparation of financial statements, however, not every business entity has the accrued revenues in the financial records. Most businesses recover the revenues for services rendered within the same financial period, and revenues are not accrued. Therefore, the recognition of accrued revenues is occasional in such business entities.
However, there are some types of business entities and industries where the accrued revenues are more common than other businesses. Following are the types of work or projects when recognition of accrued revenues is more common:
Milestone based work
When a business entity is involved in milestone-based work, the percentage of completion method is used to record the scope of completed work as the accrued revenues for the business entity.
Long term projects
Many long-term projects spread over the years cannot be recorded in one financial period. The payment of such projects is also made at the end of the project usually. Therefore, the companies record accrued revenues until and unless the complete payment for the completed work has not been received.
The financial institutions also record accrued revenues more often than other business entities. When a bank issues a loan, the interest starts accruing from the day of issuance. However, the bank receives the loan periodically. It can be monthly, annually, quarterly, or bi-annually. Since the interest is revenue for the bank, the accounting books record interest as accrued revenues until it is credited in accounts of financial statements.
Preconditions for recording accrued revenues
It is a general misunderstanding that a business entity can record the revenues as accrued revenues whenever appropriate. However, it is not the case. Certain preconditions must be met in order to recognize revenue as the accrued revenue or revenue receivable.
Following are the preconditions for recording the revenues as accrued revenue:
- The company must have earned revenues by delivering the goods or services to the customers. If the condition fulfills, only then a business entity can record its revenue as accrued.
- Only the part of the goods and services delivered should be recognized as the accrued revenue in the accounting books.
- The goods and services provided to the customers must be measurable in terms of financial value. Otherwise, they won’t be recognized as the accrued revenue.
- It is the responsibility of a business entity to evaluate the customer before allowing him credit. If the assessment gives reasonable certainty that the customer will pay for services in the future, the accrued revenues should be recorded.
Example of accrued revenues
The utility bills, salaries, rent, etc., are the most common accrued revenues in any business entity. For the examples mentioned here, the clients usually benefit from the goods or services for a whole month and pay it later.
However, let’s comprehend the concept of accrued revenues with a more detailed example.
Let’s suppose that a street coffee shop Taylor’s Coffee Corner, offering diverse cuisine options. The restaurant owner has rented the storefront of a plaza as his coffee shop. It implies that Taylor will have to pay the rent for it. The owner of the plaza is Robert Trivedi. Both of them have signed a rental agreement. According to the agreement, Taylor pays the rent for the coffee shop on the first of every following month.
Robert Trivedi prepares his annual financial statements every year by ending the period on December 31st. Every December 31st, the coffee owner has used the storefront for the whole month but has not paid yet. Therefore, the income statement of Robert records rental income because he has earned the rental but has not received it yet. In other words, the rental income is the asset of Robert, so that he will record it in the balance sheet too.
He will record the adjusting entry in his accounting books by debiting the accrued revenue and crediting the revenue account. However, when he receives rent from Taylor, he will credit the accrued revenue and debit the bank/cash account.
Accounting for accrued revenues
Now we will look at the procedure for recording the accrued expenses in the accounting books of a business entity. For illustration, we will take the above example as a reference and will explain it.
Robert Trivedi has signed the rental agreement with Taylor for 2,200 USD per month for the coffee shop. As mentioned earlier, that Taylor pays the rent on the 1st of every following month. On December 31st, the accounting books of Mr. Trivedi were closed. By December 31st, Taylor had not paid the rent, but Mr. Trivedi already earned it. Therefore he will make two adjusting entries in his books to follow the accrual-based accounting system.
The first entry will recognize the revenues earned in a specific financial period, that is, one year in the case of Mr. Trivedi. He has closed his accounts on December 31st, and the amount for accrued revenue as rent is 2,200 USD. He will pass the following entry in his accounting books:
|Accrued Rental Income||2,200|
|Rental Income Account||2,200|
The accounting books of Mr. Trivedi will also have the log for settlement when Mr. Taylor pays the rent. The following entry will be passed in accounting books on the settlement:
|Accrued Rental Income Account||2,200|
Importance of accrued revenues
Under the principle of revenue recognition, recording accrued revenues improve the accuracy of the financial statements. With the recording of the earned and receivable revenues, the agility of the business operations is improved.
As a business owner, you can anticipate the expenses and revenues in real-time. By doing so, the businesses can have an accurate estimate of profitability.
Accrued revenues are the asset accounts for the business entities and are recorded in the current assets of the balance sheet. However, if the accrued revenues of the business entity are receivable in more than 12 months, they’re recorded in the company’s long-term assets.
Accrued Revenues Vs. Unearned Revenue
You can understand the difference between accrued revenues and unearned revenues by just looking at the names. The accrued revenues are the revenues of a company that have been earned by rendering services or delivering goods before receiving the payment.
On the other hand, the unearned revenues imply that the company has received advance cash from a client before rendering services or delivering the goods. The most common example of unearned revenue is gym subscription fees, insurance premiums, software subscriptions, etc.
This article has discussed how to record the accrued revenues in the financial statements and why the accrued revenue recognition is important for any business entity. You can also understand the journal entries for the usually accrued revenues in any small business.