Financial analysis is one of the best ways to determine whether a company is investable or not. It not only gives you information about its current financial situation but also provides insights into its future growth potential. Among the many metrics you need to thoroughly analyse is accrued income. It is a crucial financial concept that directly impacts the financial statements and overall financial health of a company.
But what exactly is it, and how do companies account for it in their financial statements? In this article, we will delve into what accrued income is, its treatment in accounting and how it differs from deferred income.
What is accrued income?
Accrued income, under the accrual accounting method, represents revenue earned but not yet invoiced or received in cash. This reflects the economic performance of a business and is recorded as an asset on the balance sheet until the corresponding cash is collected.
Accrued income is essentially a result of the time lag between the delivery of goods or services and the receipt of cash. Since it signifies cash flows that a company would receive in the future, it is recognised as a current asset and is recorded on the balance sheet as such.
The primary reason why companies choose to recognise accrued income is due to the accrual system of accounting. Most companies in India follow this system, where both expenses and income are recognised as and when they are incurred and not when they are paid or received. This is in contrast to the cash system of accounting, where expenses and income are recognised only when they are paid and received respectively.
Examples of accrued income
Let us now look at a few hypothetical examples of accrued income to gain a better understanding of the concept.
- Income from services
A company that generates revenue by rendering services first and then receiving payment for them later is one of the most common examples of accrued income. Here is an example.
Imagine a consulting firm providing interior design services to a client. The firm provides the services in the month of November but generates an invoice for them only in December. Despite raising the invoice a month after providing the service, the company will still record the revenue in November as accrued income. The fact that the revenue was earned in November does not change, even though the company has not yet invoiced for it. - Credit sales
A company that has generated revenue by selling goods to its customers on credit but has yet to generate an invoice or receive payment for such sales is another classic example of accrued income.
Assume that there is a company that sells 1,000 critical engine parts to a car manufacturer each month on credit. The invoice for such sales, however, is only generated on a bimonthly basis. In this case, the revenue from the sale of 1,000 engine parts is recognised each month as accrued income, even if the invoice is yet to be generated. - Interest and rent income
The loan interest that accrues each month but is yet to be received is also considered to be accrued income in the financial statements of the company that provided the loan. Similarly, the rent income from a leased property is also recognised as accrued income by the landlord, even if the tenant fails to make the payment by the end of the month.
Features of accrued income
- Balance sheet classification: Accrued income is categorised as a current asset on the balance sheet, reflecting its immediate availability for collection.
- Revenue recognition principle: Accrued income aligns with the revenue recognition principle, which dictates that revenue should be recognised when it is earned, regardless of when cash is received.
- Timing discrepancy: A temporal disparity exists between the income statement and cash flow statement due to accrued income. While revenue is recorded on the income statement when earned, its corresponding cash inflow is not realised until a later period.
Journal entry for accrued income
To account for accrued income, a journal entry is required. The following entry is used:
Account |
Debit (INR) |
Credit (INR) |
Accrued Income |
xxx |
|
Revenue |
|
xxx |
Explanation
- Debit: The accrued income account is debited to increase the company's assets.
- Credit: The revenue account is credited to record the earned income.
This entry ensures that the accounting equation remains balanced, adhering to the principles of double-entry accounting.
What are the advantages of accrued income?
One of the major advantages of recognising accrued income is that it provides a more accurate representation of the company's financial situation. The concept works on the logic that just because a business has not yet received payment for its goods and services does not mean that it has not earned it. And since it has earned the income, it must be recognised in its financial statements.
Additionally, it also promotes transparency since it provides the company’s stakeholders with details of the income that the company is owed. Furthermore, accrued income also enables companies to better manage their cash flow and financial situation.
How to record accrued income?
To record accrued income, follow these steps:
- Identify the revenue: Determine the specific revenue earned during the period. This might include interest, rent, or services provided.
- Calculate the amount: Quantify the accrued income based on the terms of the agreement or contract.
- Create the journal entry:
- Debit: Accrued revenue (asset account)
- Credit: Revenue (income statement account)
Example: If a company has earned Rs. 1,000 in interest on a savings account but has not received a payment yet, the journal entry would be:
- Debit: Accrued interest receivable Rs. 1,000
- Credit: Interest income Rs. 1,000
By recording accrued income, businesses ensure their financial statements accurately reflect their overall financial health and provide a more comprehensive picture of their operations.
How is accrued income treated in accounting?
Now that you have seen the meaning of accrued income, let us try to understand how it is accounted for in the financial statements.
In accounting, accrued income is recorded on the income statement as revenue, even though cash has not been received. Simultaneously, it is also recognised as a current asset on the balance sheet under the heading ‘accounts receivable’.
As and when the income is actually received, necessary adjustments are made to ensure that the accrued income reflects the exact amount that is owed to the company. The adjustment is done by reducing accrued income by the amount received and crediting the cash and bank accounts of the company.
How is accrued income different from deferred income?
The meaning of accrued income is vastly different from that of deferred income. Understanding the difference between the two can help you make informed decisions when analysing a company.
As you know by now, accrued income represents revenue that the company has earned but not received.
Deferred income, meanwhile, represents revenue that the company has received but not yet earned. For example, if a customer pays for a subscription service upfront for an entire year, the revenue would be recognised as deferred income by the company offering the said service. In other words, deferred income is a company receiving cash in advance for goods or services that it will provide in the future.
Unlike accrued income, deferred income is recognised as a current liability in a company's balance sheet despite being recorded as revenue in its income statement.
Conclusion
Accurate recognition of accrued income is crucial to ensuring that the financial statements reflect the true picture of a company’s performance. In addition to recognising it, companies must also ensure that their accrued income is adjusted as and when they receive the payments. Failure to make timely adjustments could lead to errors and a misrepresentation of the company’s finances.
As an investor, when analysing a company's various financial statements, you must pay attention to how the company has recognised its accrued income. Additionally, you should also try to assess whether appropriate adjustments have been made to account for the payments received by the company.
