Four Conditions for Recognizing Revenue Under Accrual Accounting

Accrual basis accounting records financial transactions as they occur. Accrual accounting does not require cash to change hands during a financial transaction. Generally accepted accounting principles (GAAP) require accounting methods to meet four revenue recognition conditions. These conditions occur during each financial transaction and must be recorded during the accounting process. Business owners should pay close attention to these conditions to ensure they do not record inaccurate or invalid financial information.

Evidence of Arrangement

Accrual basis accounting requires an evidence of arrangement condition. Financial transactions must occur between a buyer and seller in an arms-length transaction. Arms-length transactions occur free from undue pressure and without collusion between the buyer and seller. The evidence of arrangement condition does not require a formal written contract. Individuals and businesses engage in these types of arrangements in just about every business environment. Revenue is unrecognizable unless an evidence of arrangement is in place.

Delivery or Services Rendered

The delivery of goods and rendering of services are another condition of accrual accounting. Delivery of goods usually requires the seller to give full possession of an item to the buyer. The location of delivery (buyer or seller’s facilities) is not a factor in this requirement. Rendering services is similar to the delivery of goods. The seller must complete all services in the transaction to ensure it meets accrual basis accounting requirements.

Price Is Fixed or Determinable

Accrual basis accounting requires the price of goods or services to be fixed or determinable. Buyers and sellers must be unable to change the price once the evidence of arrangement exists. Altering financial information outside of the original agreement can create dangerous business situations. Buyers and seller must both agree to any changes in arms-length financial transactions. This ensures all information relating to a financial transaction is included in the price of the goods or service.

Collectability is Reasonably Assured

Accrual accounting requires financial transactions to include a reasonable assurance of collectability. Many businesses sell goods or services on account. Account purchases allow buyers to pay for items over time rather than all at once. Reasonable assurance means sellers are confident that outstanding account balances will be paid by the buyer. Collectability means open account balances are in good standing with buyers and sellers. Business owners usually issue an invoice requesting final payment from the buyer as part of the collectability process.

References

• "Accounting;" Charles T. Horngren and Walter T. Harrison, Jr.; 2007