Question

Emerald Motors is an automobile dealer. The controller consults with you about the type of accounting used for a special offer to its new car customers. Emerald has offered to provide at no charge to the customer the first four recommended service visits (i.e., at 3,000, 6,000, 9,000, and 12,000 miles). It is a virtual certainty that all customers will exercise their rights to the service, and the cost of the services can be accurately estimated. The controller reasons that the estimated cost should be accrued when the sale of an automobile is made so that all of the costs of the sale can be matched with the revenue. How would you respond to the controller?

Answer 1

Explanation-

Going by the matching principle and accrual concept, which states that revenue and expenses should be recognised when it is probable that-

(1). Risks and rewards related to goods has been transferred to buyer.

(2). The collection of payment is reasonably certain.

(3). The amount of revenue and expenses related to the sale can be reasonably measured.

According to the accrual concept, if the cost can be reasonably estimated and it is reasonably certain that the cost will be incurred, then such cost should be reflected in the Accounts. Accrual concept states that revenue and costs should be recognised when the sale takes place and not when the cash is realized. It prevents the unnecessary inflating of profitability and shows true picture of profitability.

According to the above explanation, the method of accounting adopted by the Emerald Motors is correct, that cost of service visits should be accrued when the sale of an automobile is made since,

(1). It is a virtual certainty that all customers will exercise their rights to the service; and

(2). The cost of the services can be reasonably estimated.

Therefore, Emerald Motors should adopt accrual method of accounting.