Accrued revenue is revenue that has been earned by providing goods or services but the payment has yet to be received. In other words, cash collection will occur in a subsequent period after the goods or services have been provided.
Since it comes with the customer’s future obligation to pay, an accrued revenue account on the balance sheet will appear when the related revenue is first booked on the income statement.
As the payments are received, the accrued revenue account is reduced by the amount of cash received, with no further impact on the income statement.
Preconditions for Booking Accrued Revenue
To avoid abuses and for a correct representation of a company’s activities on its financial statements, accounting rules require that certain conditions are met before accrued revenue is booked:
The company must have delivered the products or services (or a portion of them) to its customers. If only a part of the products or services has been delivered, the company can estimate and book only the revenue for the portion delivered;
The company has reasonable certainty that it will be able to collect the payment;
There is persuasive evidence of an arrangement in the form of a written agreement, binding purchase, or another form of digital evidence; and
The price of the goods or services sold is fixed or easily determinable.
When Does Accrued Revenue Occur?
According to the rules of accrual accounting, revenue should be booked on the income statement when earned and not when the related payment has been received. A potential mismatch between the time a payment is made and when the related goods or services are delivered can create a situation where accrued revenue must be booked.
If the pre-conditions discussed are met, it can happen in several cases. For example:
When a company loans money to other companies or individuals;
When a company is involved in long-term projects and books revenue using the percentage of completion method;
When a company is working on a large order and books revenue based on milestones met.
Let us look at the cases a bit more in detail.
Accrued Revenue for Loans
When a bank or other company loans money for profit, it accrues interest revenue over the period of the loan, while the payment is generally made at specific points in time. Therefore, the company can report accrued revenue every month or quarter, even if the interest payment is received only once per year.
For example, Company A can lend $100,000 to company B in a one-year loan with a 6% interest rate to be paid at the end of the year together with the full repayment of principal. Every quarter of the year, Company A reports $1,500 in revenue on the income statement and an equal amount as an asset on the balance sheet, although no cash inflow is reported. Only at the end of the year, the full amount of $6,000 is received, and the related asset on the balance sheet is reduced by the amount of revenue accrued until then.
The diagram below explains the various steps of the process:
Accrued Revenue for Long-Term Projects
When a company is working on a long-term project, it may be booking revenue according to the percentage of completion method. In this situation, the company is allowed to book revenue based on the costs incurred for the completion of the project.
Let’s take the example of Company A, which is working on a certain project worth $1,800,000. To complete the project, the company estimates to bear costs for $1,200,000 and expects the project to be completed in two years.
After the first year, the company has borne costs for $800,000, or two-thirds of the total. In this scenario, Company A is allowed to book two-thirds of the contract value ($1,200,000) as revenue for the year.
In the second year, the company bears the remaining one-third of the costs ($400,000) and is allowed to book the remaining one-third of the contract value as revenue for the year ($600,000).
The company receives the entire payment for the project only in year three. This generates a cash inflow and a reduction of assets on the balance sheet without any impact on the income statement.
The diagram below explains the various steps:
Accrued Revenue for Milestones
When a company is working on an order that has multiple deliverables, it can book revenue according to the milestone method. The company can identify specific milestones and book revenue as those milestones are completed.
For example, let’s examine a company that produces airplanes working on a bulk order. Company A, an airplane manufacturer, has received an order of four airplanes from an airline company. The total value of the contract is $800 million or $200 million per airplane. Company A will receive the payment when the entire order is delivered but has set the completion of each airplane as a milestone for booking revenue.
At the end of year 1, Company A has completed two airplanes and is working on the remaining two. According to the milestones set, Company A can book $400 million of revenue in year 1.
At the end of year 2, Company A has completed the remaining airplanes and can now book the remaining $400 million in revenue while receiving the payment from the airline company.
The diagram below shows the simple steps:
Accrued Revenue and Business Performance
Accrued revenue is particularly important for companies that make loans (such as banks) or that work on long-term projects or bulk orders for complex goods.
Estimates and management’s discretion play an important role in these situations; therefore, it’s important to analyze the way accrued revenue is estimated and booked. Accrual accounting can be subject to abuses from management teams that want to overstate a business’ performance, and analysts and investors need to understand the logic used when accrued revenue is booked.
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