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Sales Basis Method of Revenue Recognition
The accountant determines income by subtracting expenses from revenues. As simple as this may seem, there are many complexities that arise when trying to implement this concept. For example, there are many activities and events that must take place to generate revenues. The accountant adopts the procedure of recognizing revenues at the time a certain critical event takes place. The sales (or accrual) basis is the most widely used method for recognizing revenues. Revenues are assumed to be earned at the time the sale is made, even though the cash may not have been collected from customers. For companies that produce to open stock, the sale is the critical event for revenue recognition. Even though value is added to goods through the production process, these companies face considerable uncertainty about who the customer will be and about the amount and timing of the
sale. It is necessary to have an arm’s length transaction, in which the customer is legally obligated
to pay for the merchandise or service. Such factors as the signing of a sales contract and the delivery of the product provide evidence that the sale has been made. At the time of the sale, revenue is recognized and the amount due from the customer is reflected as an asset such as accounts receivable. However, some uncertainty still remains about cash receipt. Companies that use the sales method must also be able to estimate bad debts or doubtful accounts at the time of the sale so that the sales amounts and accounts receivable balances can be adjusted to reflect the expected cash receipts. The production, sales, or cash receipts method can be used to assign revenues to periods of time. Expense recognition involves assigning or matching expenses to periods of time. Some expenses are closely related to the revenues assigned to periods of time. For example, the costs of goods sold during a period reflect the costs of materials, labor, and manufacturing overhead incurred to produce units of product that were sold. These costs are called product expenses.