Whilst reading a blog related to accounting and finance, you might have heard about accrued expenses and accrued revenue. The first question that come to your mind will be somehow ‘What is accrued expense?’ and ‘What is accrued revenue?’. Similarly, you might be searching for the meaning of accrued expense and meaning of accrued revenue. If these terms are confusing you, you need not to worry as we are discussing accrued expenses and accrued revenue in detail.
What is Accrued Expense
An expense which has been incurred in the current accounting period but has not been paid in the current accounting period is called accrued expense. It is widely said that market runs on credit and trust. Things have changed and now every business require a period of 30-90 days to pay due expenses. This is where accrued expense arises. Accrued expense is in line with matching concept of accounting as well as the accrual basis of accounting.
Example of Accrued Expenses
Suppose Falcon Coffee Shop (FCS) has an agreement with its supplier where FCS is entitled to a 75 days credit. It has ordered inventory costing $10,000 on 5th December, 2019. Now as per the contract, FCS should pay the amount on 18th February, 2020 (After 75 days). Now let me ask you two questions:
As FCS is paying on 18th February 2020, should it record it as an expense on 18th Feb?
As FCS has received inventory on 5th December 2019, should it record it as an expense on 5th December 2019?
The answers are simple:
FCS should record it as an expense on 5th December, 2019. But as it has not paid for this expense yet, so it should record it as a liability on that date i.e. in 2019. This is because this expense relates to 2019 and not to 2020.
Now, when FCS pays for this expense on 18th February 2020, it should reverse the liability and decrease the cash balance by $10,000.
A revenue or an income which has been earned in the current accounting period but cash has not been received yet is called accrued revenue. It is also called as accrued income. Nowadays, cash is not received immediately, potential customers often require some time period to settle their debt. Therefore, the concept of accrued revenuer is much more common in the services industry whilst it is less common in manufacturing industry.
Why do we use the concept of Accrued Revenue?
The concept of accrued revenue is introduced to match all the incomes for the period with all the expenses for the period. Hence, it is used for Matching Concept and Accrual Basis of Accounting.
Example of Accrued Revenue
Suppose Falcon Coffee Shop supplied coffee worth of $500 to Xiya Microfinance Bank Limited in the month of December 2019. Xiya Microfinance Bank Ltd has an agreement with FCS to pay them after 60 days. Now as per the contract, Xiya MBL must pay the amount on 29th February,2020. Let me ask you two simple questions here:
As FCS has made the supply to Xiya MBL in the month of December 2019, should it record the income in December or when cash is actually received on 29th February 2020?
The answer is December 2019. As this sale of coffee relates to December 2019, that’s why it as income of 2019 not 2020. FCS should record accrued income of $500 as Current Asset in the financial statements for the year ended 31st Dec, 2019. When it has received the cash in Feb 2020, it should reverse the current assets by the same $500 amount.
That was all about accrued expenses and accrued revenues, if you have any doubt about accrued expenses and accrued revenues, you can comment down. We will answer your queries ASAP.
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