When should expenses and revenues be recognized? When talking about the timing of revenue or expense recognition, two “methods” of accounting exist: cash basis accounting and accrual basis accounting.

Under the cash basis accounting, revenues are recognized when cash is received, regardless of time services are provided or products are sold; and expenses are recognized when cash is paid, regardless of time costs are incurred.

On the other hand, under the accrual basis accounting, revenues and expenses are recorded when earned and incurred, accordingly, regardless of time cash is exchanged (i.e. received or paid).

Under the accrual basis accounting, revenue is recognized when it is (i) earned (i.e. products are delivered or services are provided), and (ii) realized (i.e. cash is received) or realizable (i.e. it is reasonable to expect that cash will be collected in the future).

Under the accrual basis accounting, expenses are recognized in the period related revenues are recognized (i.e. the matching principle).

The time differences in recognizing revenues and expenses (between the cash basis and accrual basis accounting) result in the following adjusting entries at the end of the period under the accrual basis accounting:

To accrue = to accumulate; to pile up; to increase, etc.

Accrued revenues (also called accrued assets) represent money earned (for providing services or selling and delivering products) but not received in the current period. In other words, accrued revenue is earned but is not yet received in cash or other assets.

Accrued revenues are reported under the current assets in the balance sheet. To recognize earned revenue, before cash is received, a company debits (increases) a current asset and credits (increases) a revenue account. If the company does not make such an adjusting entry, revenue and net income (in the income statement) as well as current assets and equity (in the balance sheet) will be understated.

Accrued revenue example

On December 10, 2009 BetterBusiness Inc., a security services company signs a contract with a manufacturing company for 90 days of plant security services.  Services start on December 14, 2009 and remuneration is a fixed fee of $10,800. Services are to be provided every day and thus, evenly over the 90-day period.  At December 31, 2009, BetterBusiness Inc. had provided 18 days of security services. However, since all services have not been provided yet, the service company has not billed the manufacturing company. Nevertheless, BetterBusiness Inc. has already earned 20% or 1/5 (i.e. 18/90 x 100% = 20%) of the service fee.

Under the accrual basis accounting, BetterBusiness Inc. should recognize 20% of its services revenue and report it on its income statement at December 31, 2009. Thus, the company should debit Accounts Receivable for $2,160 (i.e. $10,800 x 20%) and credit Services Revenue for the same amount.  In January and February 2010, the company will recognize 34.44% (i.e. 31/90 x 100%) and 31.11% of service fees, accordingly.  Thus, the company will debit Accounts Receivable and credit Services Revenue for $3,720 (i.e. 34.44% x $10,800) in January and $3,360 (i.e. 31.11% x $10,800) in February 2010.

In March 2010, the company provided 13 days of services (13/90 or 14.44% of entire services amount). On March 13, 2010 the manufacturing company paid the entire fee of $10,800. BetterBusiness Inc. should debit Cash for $10,800, credit Accounts Receivable for $9,240 (the total amount recorded from December 14, 2009 to February 28, 2010 for the earned revenue) and credit Services Revenue for $1,560. The $1,560 (i.e. 14.44% x $10,800) credit represents the services revenue earned in March 2010.