What is accrued income?

Accrued income is the money earned by a company by selling products or services for which payment has not yet been received.

Accrued income examples can be a lawyer charging clients by the hour and only billing an invoice after completion of work, or real estate developers accepting payments from clients at different phases of a construction.

Interest incomes earned from investments in bonds, which are typically paid semi-annually or annually, are also classified as accrued income.

Accrued income meaning: How does it work?

Accrual accounting and cash accounting make up the two standard financial accounting standards. The former recognises revenue earned regardless of cash received and the latter only records revenue on cash exchanged for goods and services.

Accrual accounting is based on the principle that revenue or expense must be recognised at the time of the transaction and not when payment is paid or received. For example, a machinery dealer sells equipment to a factory in March and gives the factory time till June to make payments. The dealer will recognise the sale and the factory will record its expense in March, even though the payment is due in June.

This type of accounting gives a more accurate picture of a company’s financial health. Accrued income in the balance sheet is listed in the asset section because it represents future payments to the company.

In 2014, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) introduced a global standard on recognition of revenue from contracts with customers to “improve comparability of the top line in financial statements globally.”

“Revenue is one of the most important measures used by investors in assessing a company’s performance and prospects. However, revenue recognition guidance differs in Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) — and many believe both standards are in need of improvement,” said FASB.

Accrual accounting vs cash accounting

Entities using the accrual accounting method have to pay taxes on receipts recognised whether it is received or not. In the case of the cash accounting method, entities will only be taxed on income actually received and recorded.

So does this make cash accounting the better accounting method to use to reduce tax liability?

According to India-based private insurance company Future Generali, cash accounting will only postpone tax payment and not actually reduce it.

“If receipts are expected to be irregular and uncertain, the accrual method will put more significant strain on financial planning. What way is suitable depends on the type of profession/business,” said Future Generali.

Who can use accrual accounting?

Most companies use accrual accounting as their accounting standard, while smaller companies and individuals can choose their preferred method if their revenue is below a certain threshold specified by the US Internal Revenue Service (IRS).

For example, in the US, taxpayers are exempt from using accrual accounting if average annual gross receipts of the preceding three years does not exceed $25m.