Many investors get intimidated by accounting concepts, but it's important to understand how a company brings in revenue, and how much of that money makes it to the bottom line in the form of profit. In analyzing top-line revenue results, you need to understand a couple of very different but equally important concepts: accrued revenue and unearned revenue.
You'll find both of these items on financial statements. How much of each a company shows on its balance sheet can reveal more about how the company operates. Let's take a closer look at each concept.
Accrued revenue is a concept that just about everyone can understand, because it mirrors how the vast majority of workers get paid. Most jobs involve the worker putting in anywhere from a week to a month of work before getting a paycheck covering the period immediately past.
Similarly, many companies end up doing work upfront before they can bill their customers for that work and collect revenue. In order to acknowledge the value of the work that the company has already done, the expected future revenue from that work gets booked as accrued revenue.
Accrued revenue is common in the service industry, as most customers aren't willing to make full upfront payments for services that the provider hasn't yet rendered. Once a company actually bills the customer for the work it has done, the asset is no longer treated as accrued revenue, but rather as an account receivable until the customer pays the bill.
Accrued revenue is an asset, but it's not as valuable an asset as cash. That's because it takes the effort of billing and collecting from the customer to transform accrued revenue into cash. Having high amounts of accrued revenue on the balance sheet can be a sign that a company isn't efficient at getting its customers to pay for its services.
By contrast, unearned revenue represents the opposite situation in which a customer prepays for a good or service. In order to balance the cash that the company receives in such a transaction, the company books the value of the goods or services that it's obligated to provide as unearned revenue, which is a liability.
Unearned revenue is common in the insurance industry, where customers often pay for an entire year's worth of coverage in a single upfront premium. As time passes and the company delivers the goods or services to its customers, that unearned revenue turns into current revenue that is included on the income statement. Without this treatment of unearned revenue, the company's accounting would inaccurately reflect its efforts to bring in that revenue over time, instead, simply relying on the time of payment and making revenue streams much more volatile.
Companies that have a lot of unearned revenue are at an advantage in that they have the use of their customers' cash even before they've done the work to earn it. Some insurance companies have used this concept of float as a major profit driver.
As an investor, you'll run into both accrued revenue and unearned revenue in your research of various companies. Knowing the difference is essential to understanding a company's overall financial situation.
And once you understand a company's finances, you may want to buy its stock, which requires a brokerage account. Our site has a great section where you can compare various brokers, and figure out which one is the best choice for your investing needs.
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