Accrued income is an income earned but not yet collected. For example, a company performs services in one month but does not receive payments for the services until the following month. The company would record revenues in the month when services are performed under the accrual accounting method and in the month when the payments are collected under the cash accounting method.
Accrual accounting method
Accrual accounting is a method of accounting that seeks to match expenses and sales to the period when they occurred. Hence, a company record accrued income (revenues) when they are earned, even though they have not been yet collected. It is opposite to cash accounting where income is recorded when payments are collected or received. Most companies use accrual accounting, as it is more convenient.
Accrual accounting is reliance on two principles:
- Revenue recognition principle – revenues are recorded when a company performs the services and receipt of cash is reasonably expected.
- Matching principle – expenses are recorded in the same period that related revenues are accrued.
Accrual accounting example:
A computer repair company fixes your laptop on November 21, 2018 and bills you for the service. You pay the bill and the company receives proceeds on December 20, 2018, due date on the invoice. The revenue recognition principle requires that the company records revenue in November 2018, when the service was performed. The matching principle requires that the company also records the expenses related to the delivery of this service (labor costs) in November 2018.
Proposed accounting entries:
- Debit: Accounts Receivable (asset account)
- Credit: Service income (revenue account)
(accounting entry to record revenues in November 2018)
- Debit: Labor costs (expense account)
- Credit: Wages payable (liability account)
(accounting entry to record expenses in November 2018)
The collection of cash for the service (cash inflow) will be recorded in December 2018 as follow:
- Debit: Cash (asset account)
- Credit: Accounts Receivable (asset account)
The payment of wages (cash outflow) will be recorded at the end of pay period (December 1, 2018):
- Debit: Wages payable (liability account)
- Credit: Cash (asset account)
Impact on earnings performance
Studies determined that accrual accounting improves earnings’ ability to reflect firm performance. The users of financial information are primarily concerned with a firm's ability to generate cash flows. However, cash flows coming in at various times do not appropriately reflect a company's performance in a specific time frame or interval (fiscal year). The usage of accrual accounting promotes a more consistent measure and it smooths out the erratic cash flow inflows in reporting of financial information. Accrual accounting mitigates timing and matching problems in cash flows therefore it generates information that is more useful in measuring and comparing firm performance, from one period to another.
However, accrual accounting creates opportunities for judgements, which may generate accounting errors. More complex projects or services that are performed over a longer period require management to estimate a percentage of completion to determine the amount of revenues that must be reported for the current period. Management may be motivated to overestimate the revenues to better reflect earnings performance in the current period. At the same time, the matching principle requires that expenses are matched with revenues in the same period. Management again may have to use judgements to estimate expenses due to complexity of the projects, which could potentially result in underestimation of expenses in the current period.
While accrual accounting method is preferred for reporting purposes, it is not as useful in budgeting or forecasting when actual cash flows are partially within one accounting period and partially outside it. That's because the relationship between end of year equivalent cash flows (actual cash flow) to the yearly accounting figures (reported cash flow) is weak. Cash accounting method better represents actual cash flows and therefore results in more useful budgets when business cash flows fall in different reporting periods.
- Dechow, P. (1994). Accounting earnings and cash flows as measures of firm performance. The role of accounting accruals, Journal of accounting and economics, 18.1: 3-42. Introduction, p. 4-5, 1
- Kroll, Y. (1985). On the difference between accrual accounting figures and cash flows: the case of working capital, Financial management, Vol. 14, No. 1, p. 75-82. Introduction, p. 76.
- Metzger, C. (2016). Accounting of pay-as-you-go pension schemes using accrued-to-date liabilities–An example for Switzerland, Accounting of pay-as-you-go pension schemes using accrued-to-date liabilities– An example for Switzerland, Introduction, 2
- Dechow, P. (1994)
- Dechow, P. (1994)
- Dechow, P. (1994)
- Kroll, Y. (1985)
Author: Daniel Gaura