When starting out in your accounting studies some of the earliest material to be covered is that concerning accounting principles. These are the fundamental understandings or agreements in the field that facilitate not only the preparation of account material but also its interpretation. One of the key principles or concepts in account is that of accruals and in particular how it impacts on when earned revenue is reported.
In todays article we will be focusing on revenue, but the principles and concepts discussed are the same.
The short answer to the question is the accrual concept or principle. This means transactions are recorded (or recognised) when there is a flow of economic benefits or obligations, not necessarily when cash moves. If you would like further explanation, along with an example and journal entries … please read on.
What is Earned Revenue?
Although a little technical, the best place to go for the definition of accounting terms is the conceptual frameworks, and in particular that which overseas financial reporting worldwide by the International Financial Reporting Standards. In their conceptual framework they define revenue (they use the term income) as:
Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.http://eifrs.ifrs.org/eifrs/bnstandards/en/framework.pdf
So for a business these types of transactions would be sales to customers, interest and dividends from investments and in some cases may include realised capital gains.
Within the conceptual frameworks these days the term “earned” attached to revenue is not really required as a transaction can only be recognised in the accounting records if it has been earned. If it hasn’t been earned, for example money is received for work that hasn’t been, this is not deemed to be income for the business. We have a whole article on this issue on accrued or earned revenue and that can be found here.
But I might hear you ask, so what about those businesses that work on a cash basis? How is that different?
Accrual v Cash Accounting
The term “cash accounting” is a little misleading in that people often think it applies to businesses that deal only in cash. This may be true, but not because they deal in “cash”. What the term means is revenue (or income) is recognised not when “earned” by a business but when they actually receive payment. Now this payment may be in cash, cheque, bitcoin or seashells; the form doesn’t really matter. What matters is when they receive that payment is when they record the revenue.
Let’s look at a simple example. You operate a home decoration business and you have a small contract to do some exterior painting on a client’s home. In the “cash accounting world you would make the following accounting entry when you received the cash:
Now under accrual accounting the opposite is true. It doesn’t matter when the payment is received, what matters is when the earned revenue is reported. Carrying on the example from above, the journal entries would be a little different (lets assume we give the client 30 days to pay):
Under the accrual accounting principle we have recognised the “earned” revenue of $700 because we now have asset in the form of an increase in debtors – ie people who owe us money.
In February when the client pays you the following entry would be made in your business accounting records:
This entry reduces the debtors asset balance by $700, because that asset has now been discharged; in effect replaced by the increase in the bank asset of $700.
We hope you have found this article useful. When you look at the simple example we covered on when earned revenue gets reported, a couple of things are worth noting:
- the cash accounting system is simplier and often the reason it is used by small businesses; and
- in the end the only difference is that of timing, ie when transactions are brought to account rather than overall any material difference in information the systems provide.