What is Accrued Income?
Accrued income is money a person or company has earned but not yet received. The income has been recorded in the accounting records, but the cash has not been collected yet. Accrued income is an essential concept in accounting that helps to match income with the period when it was appropriately earned.
How Accrued Income Works
In accrual-basis accounting, income is recorded when earned, not when received. This means that a company’s revenue at a certain period includes all the money earned during that time, even if some payments will be received later.
For example, imagine a small business that does web design work for clients. On December 15th, the company finishes a big web design project and sends an invoice to the client for $5,000. The client has 30 days to pay the invoice. Even though the company has not yet received the $5,000 payment from the client, it will still record the $5,000 as income in December because that is when the money was earned. The $5,000 is accrued income.
Why is Accrued Income Important?
Accrued income is significant because it helps to give a more accurate picture of a company’s financial performance. A company’s financial statements will show how much money the business made during a specific period by recording income when it is earned rather than when it is received.
This is especially important for businesses in a long period between providing a service and getting paid. If a company only recorded income when it received cash payments, its financial records would be misleading. It might look like the company had a meager income in one month and a very high income in the next month when it was earning consistently the whole time.
How to Record Accrued Income
To record accrued income, a company makes an adjusting entry in its accounting journals at the end of the accounting period. The adjusting entry debits (increases) an accrued income account and credits (increases) a revenue account.
Accrued Income Journal Entry Example
Let’s go back to our earlier example of the web design company. The company finished a project on December 15th and sent the client a $5,000 invoice. On December 31st, the last day of the accounting period, the company would make the following adjusting entry:
The company would debit Accrued Income for $5,000 and credit revenue for $5,000.
This entry increases the accrued income account, an asset account on the balance sheet, and the revenue account, which is reported on the income statement.
When the company receives the $5,000 payment from the client in January, it will make another journal entry to record the receipt of cash and to clear out the accrued income account:
The company would debit cash for $5,000 and credit Accrued Income for $5,000.
Reversing Entries for Accrued Income
Some companies use reversing entries with their accrued income. A reversing entry is an optional entry made at the beginning of a new accounting period to undo the adjusting entry made at the end of the previous period.
In our web design company example, the company would make this reversing entry on January 1st:
The company would debit revenue for $5revenued credit Accrued Income for $5,000.
Thenrevenuethe company receives the $5,000 cash payment later in January; it would record the receipt with this entry:
The company would debit cash for $5,000 and credit revenue for $5,000.
The result is the same whether the company uses a reversing entry. The reversing entry is just a way to simplify the record-keeping process. If a company has a lot of accrued income at the end of an accounting period, reversing entries can make it easier to track which revenues have been collected and which are still outstanding.
Accrued Income vs. Accounts Receivable
Accrued income and accounts receivable are related concepts, but they are not the same thing. Accounts receivable is money a company has a right to receive because it has provided goods or services. Accrued income is money a company has earned but has not yet received.
In many cases, accrued income and accounts receivable will be the same amount. In our web design company example, the $5,000 amount is both accrued income and accounts receivable. The company has earned $5,000 (accumulated income) and has the right to receive $5,000 (accounts receivable) because it has completed the web design services.
However, there can be cases where accrued income and accounts receivable are different. For instance, imagine that the web design company has a contract that bills the client $1,000 monthly for ongoing website maintenance. At the end of December, the company would record $1,000 of accrued income for the services it provided in December. However, its accounts receivable would be $3,000 if the client is on a quarterly billing cycle and hasn’t been billed since the end of September.
The Importance of Accrued Income in Financial Statements
Accrued income is an integral part of a company’s financial statements. It is included as an asset on the balance sheet and as revenue on the statement.
The balance sheet, accrue revenue, is typically listed under the current assets section. Current assets are expected to be converted into cash within one year. Accrued income is considered a current asset because it represents money the company expects to receive soon.
Accrued income is reported as part of the company’s revenues on the income statement. The income statement shows a company’s revenues and expenses over a certain period. By including accrued income, the income statement gives a more complete picture of the company’s revenue-generating activities.
Why Investors and Creditors Care About Accrued Income
Accrued income is essential for investors and creditors because it provides insight into a company’s financial health and performance.
For investors, accrued income can indicate that a company is effectively generating revenue. If a significant amount of revenue has accrued, revenue suggests that the company is making sales or providing services, even if it hasn’t collected all the cash yet. This can be a positive sign for the company’s future financial performance.
However, investors must also consider how long a company can convert its accrued income into cash receipts. If a company has a lot of accrued income that is taking a long time to collect, it could be a sign that it is having trouble getting clients to pay their bills. This could indicate potential cash flow problems in the future.
Creditors, such as banks that lend money to a company, are also interested in accrued income. Accrued income is an asset that can potentially be used to pay back debts. However, like investors, creditors want to see that a company can promptly convert its accrued income into cash.
To wind up
Accrued income is a vital concept in accounting that reflects income that has been earned but not yet received. It is essential because it helps provide a more accurate picture of a company’s financial performance, especially for businesses with a significant time lag between providing services and receiving payment.
By recording accrued income, a company’s financial statements will show the income earned during the accounting period, regardless of when the cash is collected. This is crucial information for investors, creditors, and anyone else who needs to evaluate a company’s financial health and performance.
While accrued income is closely related to accounts receivable, they are not always the same amount. Understanding the differences between these two concepts is essential for adequately managing and reporting a company’s finances.
In the end, accrued income is a vital piece of the financial puzzle for any business that uses accrual-based accounting. By adequately recording and tracking accrued income, companies can better understand their financial position and make more informed decisions about operations and growth strategies.
