Accruals accounting is based on the matching of costs with the revenue they generate. It is crucially important under this convention that we can establish the point at which revenue may be recognized so that the correct treatment can be applied to the related costs.
For example, the costs of stock should be carried as an asset in the balance sheet until such time as it is sold; they should then be written off as a charge to the trading account.
Therefore accountants must be clear be clear at what moment the sale of the item takes place. The decision has a direct impact on profit since under the prudence concept it is unacceptable to recognize the profit on sale until a sale has taken place.
Revenue is generally recognized as earned at the point of sale, because at that point four criteria will generally have been met.
- The product or service has been provided to the buyer.
- The buyer has recognized his liability to pay for the goods or services provided and the seller has recognized that ownership of goods has passed from himself to the buyer.
- The buyer has indicated his willingness to hand over cash or other assets in settlement of his liability.
- The monetary value of the goods or services has been established.
At earlier point of business cycle there will not in general be firm evidence that the above criteria will be met. Until work on a product is complete, there is a risk that some flaw in the manufacturing process will necessitate its writing off; even when the product is complete there is no guarantee that is will find a buyer.
At later points in the business cycle, for example when cash is received for the sale, the recognition of revenue may occur in a period later than that in which the related costs were charged. Revenue recognition would then depend on fortuitous circumstances, such as the cash flow of a company’s debtors, and might fluctuate misleadingly from one period to another.