What is Accrued Revenue?
Understanding the concept of accrued revenue is essential for any business, regardless of its size and complexity.
By tracking and accounting for all of your current earnings with this principle, you can maximize both short-term profits and long-term growth potential.
But what exactly is accrued revenue? How do businesses measure it? And most importantly, how can you ensure that your company efficiently leverages this important tool to improve its financial savvy?
Accrued revenue originates from one of the accounting bases known as “Accruals.” Accounting bases can be divided into two:
Accrual Basis
Cash Basis
Cash basis focuses only on when cash is received for a transaction, while accrual is the opposite. Accrual can either be an expense or an income (Revenue).
Primarily, our focus will be on accrued revenue, what it is, and how to leverage it.
What is Accrued Revenue?
Accrued revenue is a kind of revenue that is recognized when it has been earned, not when it has been received or paid. This kind of revenue flows into the business when it has been agreed that economic benefits (Money) will be earned.
Suppose Zuora, a billing company, acquires a startup customer who needs their billing service for the next three months. A contract is signed to deliver the service for $5000 monthly. Zuora then agrees to send a monthly invoice payable on the 10th of the following month. Zuora will have $5000 in accrued revenue from that customer until the end of the contract.
Put another way, when a tomato seller sells their tomatoes, they expect money to be paid for the tomatoes. Accrued revenue states that even if the buyer fails to pay for the tomatoes immediately and promises to pay on a later and agreed date, the money from the sale should be recognized immediately as revenue.
Accrued revenue is especially important for SaaS based businesses offering services to customers on an ongoing basis over an extended period.
Difference between accrued revenue and unbilled revenue?
Although it’s common to confuse “Accrued Revenue” and “Unbilled Revenue” because they are similar — but there is a thin line between them. The tables below show the differences between them in terms of invoice requirement and recognition in the accounting system.
Table 1: Difference in terms of invoice requirement
| Concept | Definition | Invoice required ? |
|---|---|---|
|
Accrued revenue |
Revenue that has been earned but has yet to be received and doesn’t necessarily require an invoice to be issued. |
No (Already invoiced) |
|
Unbilled revenue |
Revenue that has been earned, but an invoice needs to be issued to be paid. |
Yes (Yet to be invoiced) |
| Concept | Definition | Invoice required ? |
|---|---|---|
|
Accrued revenue |
Revenue that has been earned but has yet to be received and doesn’t necessarily require an invoice to be issued. |
No (Already invoiced) |
|
Unbilled revenue |
Revenue that has been earned, but an invoice needs to be issued to be paid. |
Yes (Yet to be invoiced) |
As shown in Table 1, the difference between the two concepts is whether an invoice is required for payment. From Table 2, we can see that the difference is in the recognition in the accounting system at different stages.
Why is accrued revenue important?
Accrued revenue is important because it helps a business to reflect the true nature of its financial statements. It ensures the financial statement is neither overstated nor understated. Accrual does not rely on when cash is received before recognizing the revenue to reflect true business performance through the financial statement.
Accrued revenue is also important as:
It brings uniformity when reporting the financial statement.
It increases the cash flow of a business.
It creates consistency and accuracy in the usage of accounting principles.
It shows the true view of the cash flow of a business for both investors and creditors.
It helps the business to track the influence of sales on its profit.
It helps to create solutions to any potential challenges that might stand against the profit.
This video explains in detail all you should know about accrued revenue.
What industries use accrued revenue?
Accrued revenue is relevant and can be used across any industry — but it’s mostly used by the following industries, such as:
Financial industry: Financial industries such as investment banks record the interest from loans as accrued revenue.
Real Estate: When rent payments are earned at the beginning of the month but are paid or received at the end of the month, and are mostly accumulated by the end of the year.
Construction industry: When construction industries engage in milestone projects, this milestone project leads to accrued revenue for these industries.
Contractors: Projects given out to contractors mostly use accrued revenue. They collect part of the money at the beginning of a project and receive the balance on completion.
Service-based industries: Most SaaS, consulting, and accounting firms rely heavily on accrued-based revenue for cash flow.
Healthcare Industry: Healthcare professionals also record accrued-based revenue after offering services to patients even though payment is yet to be received.
Manufacturing and production industries: For example, when a company sells a product to another company, but the latter pays later.
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Accrued revenue recognition criteria
The following are the criteria set by the Securities and Exchange Commission (SEC) for revenue to be recognized, they include:
Persuasive evidence of an arrangement exists
A business must have a contract or agreement with its customer, or client, to establish clear terms for the services to be delivered
Delivery has occurred, or services have been rendered
Only when the services have been rendered, and the goods have been delivered can revenue be recognized and earned.
The price is fixed and determinable
The price for the service or goods that will be provided and delivered needs to be fixed and agreed upon. The price agreed by both parties leads to the recognition of accrued revenue.
Collectibility is reasonably assured
A business cannot recognize revenue until there is evidence of payment or assurance that payment will be made at an agreed date. This assurance leads to the recognition of accrued revenue.
Accrued revenue vs. deferred revenue
| Criteria | Accrued Revenue | Deferred Revenue |
|---|---|---|
|
Definition |
Revenue earned but not yet received in cash. |
Cash received but revenue not yet earned. |
|
Recognition timing |
Revenue is recognized when it is earned, regardless of payment. |
Revenue is recognized when payment is received, regardless of service or product delivery. |
|
Economic benefits |
Service or product has been delivered or completed, but payment is yet to be received. |
Service or product has not yet been delivered or completed, but payment has already been received. |
|
Asset/Liability |
Current asset (accounts receivable). |
Current liability. |
|
Examples |
Zuora bills a client monthly for a SaaS subscription service. The client doesn’t pay until the end of the month, so zuora recognizes the revenue as accrued until payment is received. |
A client pays Zuora upfront for a year’s worth of SaaS subscription services. zuora recognizes the payment as deferred revenue until it provides the services throughout the year. |
Examples of accrued revenue
Interest on loan
A business can earn interest when it gives out funds to other businesses or individuals. The interest could be accumulated monthly or even yearly, creating accrued revenue for the business.
Example: Abc Ltd gave out a loan of $600,000 to Ghi Ltd on January 1, 2023, and at an annual interest rate of 5%. The loan agreement requires that interest be payable at each quarter’s end. By the end of the first quarter (March 31, 2023) Abc Ltd will have accrued a revenue of $7500 ($600,000 x 5% x 3/12) in interest income.
However, if Abc Ltd didn’t receive the payment of $7500 until the end of the second quarter, the revenue will still be recognized on its financial statements as accrued revenue at the end of the first quarter.
Long-term projects
A business might embark on a long-term project that will take some time to accomplish. The revenue accumulated over this period will be treated as accrued revenue.
Example: A laundry company washes a football club’s jerseys for a whole season. They offer a five-year subscription for $5000. The laundry company would recognize $1000 as accrued revenue yearly until the completion of the subscription.
Milestone project
Suppose a business embarks on a milestone project: the accrued revenue will flow into the business when the projects are achieved.
Example: Xyz Ltd, a furniture dealer, agrees with the Government to supply 20 schools in various states with furniture. The company establishes a milestone for each school, costing $35,000 per school. As the furniture company completes the supply for each school, the company will recognize the corresponding revenues as accrued revenue.
Accrued revenue for SaaS
Accrued revenue arises when there is an add-on purchase during the subscription period when there is an upgrade of downgrades and set-up fees.
Example: Bibi subscribes to a software package to listen to music for a month from an online music company; she downloaded music that was not part of the package. The additional payment for download is accrued revenue.
Two main accrual accounting principles every business should know
There are two essential accrual accounting principles every business should know. They are — Matching principle and the Revenue recognition principle.
Matching principle
Matching concept states that for any accounting period, revenue earned must match the cost of expenses incurred and reported for that year. Therefore, when preparing the financial statements, an accountant must align the revenue and expenses of that period.
Zuora sells one of its services or products in January but incurs the cost of production of the product or service in December. The cost should be recognized in December, even though the revenue will not be recognized until January.
Revenue recognition principle
The revenue recognition principle is another principle that guides accrued revenue, and it states that revenue should be recorded in the same period that the revenue is earned. As soon as a service has been enjoyed, or goods have been delivered, it should be recorded during that accounting period.
Zuora offers a client one of its billing services in January but won’t get the payment until February. According to the revenue recognition principle, the revenue should be recognized in January when the service was rendered.
What are the best practices for accrued revenue?
The following best practices for managing accrued revenue come in handy for any business, especially for SaaS companies:
Accurate recording: Ensure every revenue recognition follows the SEC criteria listed above and that all the revenue entries are accurately recorded in the books.
Timely invoicing: To prevent delays in revenue recognition, ensure invoicing is timely and accurately completed.
Regular reconciliation: To avoid discrepancies in your accrued revenue account, ensure outstanding revenues are frequently recognized and recorded correctly.
Accurate forecasting: SaaS and other businesses often plan their resources and growth around revenue forecasts. Ensure your forecast is based on historical data and past trends.
Periodic reviews: Proper documentation is key, but you should conduct regular reviews. This way, you can assess the accuracy of revenue recognition and make any necessary adjustments.
Communication: Effective communication among teams and departments is essential to ensure that all revenue is recognized accurately and on time.
Use reliable accounting software: This makes tracking and recording accrued revenues easier and streamlines the accounting process.
Monitor customer payment habits: Monitoring customer payment habits can inform how much revenue should be accrued in a given period.
Challenges in Managing Accrued Revenue
Managing accrued revenue can be complex, and businesses often encounter several challenges that can impact their financial reporting and overall operations. Here are some of the most common issues:
1. Estimation Errors
One of the primary challenges in managing accrued revenue is accurately estimating the revenue to be recognized. Businesses may struggle to determine the correct amount of revenue that should be accrued, particularly in cases where contracts involve variable pricing, discounts, or contingent payments. Inaccurate estimates can lead to overstated or understated revenue, affecting financial statements and potentially misleading stakeholders.
2. Compliance Issues
Compliance with accounting standards and regulations, such as ASC 606 or IFRS, can be a significant challenge for businesses. Organizations must ensure that their practices for recognizing accrued revenue align with these standards, which often require a deep understanding of specific criteria. Failing to comply can result in regulatory penalties, audit issues, and reputational damage.
3. Cash Flow Problems
While accrued revenue represents earnings that have been recognized, it does not equate to cash received. This discrepancy can create cash flow challenges, particularly for businesses that rely on timely payments from customers. Companies may face liquidity issues if accrued revenues are not collected promptly, leading to difficulties in meeting operational expenses and financial obligations.
4. Monitoring and Tracking
Keeping track of accrued revenue can be cumbersome, especially for businesses with multiple contracts, clients, or service offerings. Without a robust system for monitoring accrued revenues, organizations may overlook amounts that should be recognized, resulting in inaccuracies in financial reporting. Regular reconciliations and updates to accounting records are crucial but can be resource-intensive.
5. Communication Gaps
Effective communication across departments is essential for accurately managing accrued revenue. Lack of collaboration between sales, finance, and operations can lead to discrepancies in revenue recognition. For example, sales teams may promise deliverables that do not align with accounting principles, complicating revenue recognition and potentially leading to financial misstatements.
6. Technology Limitations
Many businesses rely on outdated accounting systems that may not support advanced features necessary for managing accrued revenue effectively. Inadequate software can hinder the tracking and reporting of accrued revenue, making it difficult to generate accurate financial statements or forecasts. Upgrading technology solutions may require significant investment and training.
7. Changing Regulations
The accounting landscape is continuously evolving, with new standards and regulations frequently introduced. Businesses must stay informed about these changes to ensure compliance and adapt their revenue recognition practices accordingly. This requires ongoing training and education, which can strain resources, particularly for smaller companies.
To learn more check out our ultimate guide to revenue recognition.
Accrued revenue FAQ
The following are some essential questions readers ask regarding accrued revenue.
What is an accrued expense?
Accrued expense, or accrued liability, refers to the cost incurred by a company even though payment is yet to be made. This means the company has a liability to pay for the incurred expense in the future or later date. Accrued expenses include salaries and wages, taxes, bills for forthcoming equipment, and interest on loans.
Importantly, they’re recorded under the company’s current liabilities. Accrued expenses should be reversed when they’re paid. This ensures all costs incurred are paid off and accurately recorded on the company’s balance sheet.
Why is accrued revenue an asset?
Accrued revenue is categorized as a current asset on the balance sheet as it’s the revenue the company earns for a service or goods delivered and yet to be paid.
Basically, it’s the money that a customer owes the company but has not been paid in cash or in any other format; since the company has earned money and has the right to collect it, it is an asset to the company.
Is unearned revenue accrued revenue?
No. Unearned revenue is not the same as accrued revenue; unearned revenue is also known as deferred revenue. It has been paid for but has not been enjoyed by the client or customers.
Are accrued revenues on the income statement?
Accrued revenue is recorded in the income statement on the credit side. It is often added to the gross profit and other income.
How is accrued revenue tracked and accounted for in the financial statements?
Accrued revenue can be tracked using a ledger. Each transaction is recorded in the ledger and compiled using the receivable account before being posted into the financial statements.
What is the impact of accrued revenue on a company’s financial health?
Accrued revenue increases the company’s assets, specifically its accounts receivable, and improves its liquidity. It also boosts the company’s revenue and profitability, which can improve its financial ratios and valuation metrics.
On the other hand, when accrued revenue is not accurately monitored, it can negatively affect the company’s financial health. For example, if the company overestimates its accrued revenue or does not collect it on time, it can lead to cash flow issues and increase the risk of bad debts.
Can accrued revenue be reversed or adjusted after it has been recognized?
Yes, to ensure the company’s financial statement is accurate, you can reverse or adjust accrued revenue after it has been recognized. This reversal or change can be due to a contract term, pricing, or delivery date. It can also happen if there’s uncertainty or doubt about receiving the payment from the customer.
When either of the above occurrences happen, companies need to effect the changes in the previously recognized revenue accordingly.