In today’s accounting tutorial, the last in our series on balance day adjustments, we will define this type of income and how it fits into the conceptual accounting frameworks. We will then work through an example with journal entries.
The thing to note with all of the work below on accruing income is it only relates to accrual accounting systems. So if a business is operating on a pure cash basis, you do not make these adjustments.
Definition of Accrued Revenue
Accrued revenue represents work for a customer that is completed but has not been invoiced for. Please don’t confuse accrued income with credit sales. It is not income from an invoice the customer has yet to pay; this would fall under sales and debtors. The sales journal records invoices sent to customers as a credit. At the same time, we would create a debit under the debtor’s account.
Classification of Accrued Revenue
We record accrued revenue as a current asset. Under the International Financial Reporting Standards (IFRS) Conceptual Framework, they define an asset along the lines we mention in our prepayments tutorial, being:
“… a financial arrangement that creates an obligation on a third party to expend economic benefits to our benefit.”
A fancy way of talking about a contract between two or more parties: in our accrued income, this entry arises because we have performed work or provided a good for a third party under a contract and are now expecting payment.
Creates an Obligation on a Third Party
As we have performed our side of the contract by delivering the good or service, the contract now requires the third party to perform their side of the deal and pay us the monies owed.
To Expend Future Economic Benefits
The other party in the contract needs to be something that is of economic benefit to us. That something as per the contract, and in most cases this would be to send us money.
As a Result of Past Events
The accounting standards want to ensure we are not trying to recognise contingent asset events. All conditions we set out above must be present at the balance date for the asset definition test to be passed. If they are not, then we cannot accrue the revenue.
Accrued Revenue Example and Journal Entries
So that is all of the accounting theory and concepts out of the way; it’s time to move on with the debits and credits with some journal entries—the fun part of accounting.
ABC Ltd has a year-end balance date of 31 March. As part of its financial management, it holds several liquid investments, mainly term deposits (or certificates of deposit). On March 21, a new deposit was made for $250,000, paying a generous 5 per cent per annum. This is a 30-day deposit, maturing on April 20. Because of the sums involved, the interest earnings on these deposits are accrued as of the balance date.
So we have to do a few workings to get the number we are after, which is the earnings for the ten days from March 21 (the day we entered into the deposit) to March 31 (balance date):
($250,000 x 5%) / 365 days x 10 days = $342
We can now recognise the interest earnings for the ten days as of 31 March:
|31 March||Accrued Interest||$342|||
The debit creates the accrued interest asset account, i.e. money they are entitled to receive under the contract but have not. At the same time, the credit increases the interest revenue account balance for the year.
Balance day adjustments like this are typically reversed in accounting systems after the date – the doubling up of amounts are avoided later. It keeps the system much cleaner going forward. So before the interest is recognised on April 20, we would do the following reversal journal entry:
|31 March||Interest Revenue||$342|||
And then, on April 20, when the deposit matures, and ABC receives the interest earnings, ABC would enter the following journal:
You can see that the net effect of the credit to interest revenue of $1,027 is less the interest revenue debit (from the reversal journal entry) of $342. We end up with net interest revenue recognised in April of $685.
Of course, this ignores what ABC does with the $250,000 on maturity in April, which might roll over into a new 30-day deposit. And at the end of April, ABC might perform the same accrual entry as we have done here for its internal management accounts.
Today’s tutorial covered accrued revenue and why we classify it as a current asset. We then worked through a simple example of recognising interest earnings before receiving them in the following month. We hope this has helped your understanding. If you have any questions from this or any of our material, please get in touch or drop us a question using our ask a question page.