Definition

The realization principle of accounting revolves around determining the point in time when revenues are earned.

The concept followed by the realization principle is that revenue is realized when the goods and services produced by a business are transferred to a customer, either for cash, an asset, or a promise to pay cash or other assets in the future.

Explanation

A critically important question is the following: When is profit actually earned?

The realization principle of accounting is one of the pillars of modern accounting that provides a clear answer to this question. At the same time, the realization principle also gave birth to the accrual system of accounting.

This principle states that profit is realized when goods are transferred to the buyer. Furthermore, revenue should be recognized when goods are sold or services are rendered, whether cash is received or not.

Similarly, an expense should be recognized when goods are bought or services are received, whether cash is paid or not.

According to the realization principle, revenues are not recognized unless they are realized. The point at which revenues are realized is circumstantial. For example, revenue is realized when goods are delivered to customers, not when the contract is signed to deliver the goods.

A fundamental point to remember is that revenue is earned only when goods are transferred or when services are rendered. This follows legal principles relating to the transfer of property.

There must also be a reasonable expectation that the revenue will be realized either presently or in the future. The thing to note is that revenue is not earned merely when an order is received, nor does the recognition of the revenue have to wait until cash is paid.

Examples

Consider a case where a company receives an order in April, posts the goods in May, and receives payment in June.

In this case, under the realization principle, revenue is earned in May (i.e., when the transfer took place, notwithstanding the fact that the order was received in April and cash was received in June).

As another example, consider that Mr. A sells goods worth $2,000 to Mr. B. The latter consents that the goods will be transferred after 15 days. Upon receiving the goods, Mr. B makes the payment after 10 days.

In this second example, according to the realization principle of accounting, sales are considered when the goods are transferred from Mr. A to Mr. B.

Frequently Asked Questions

What is the realization principles of accounting?

The realization principle states that revenues are only recognized when they are realized.

How does the realization Principles of Accounting affect income reported on a company's balance sheet?

Revenue has to be recognized only when sales are actually made, not when an order is received or simply entered into.

How do the realization principles of accounting affect a company's income tax report?

The same rule applies to a company's income tax return. The revenue has to be recognized when it is realized, not when an order is received.

What are the advantages and disadvantages of following the realization principles of accounting?

The main advantage is that it prevents revenue recognition mismatches. The main disadvantage is that it causes the income tax return to be more complex.

What are the advantages and disadvantages of following the realization principles of accounting?

The realization Principles of Accounting defines the point in time when revenues are earned under this premise, whereas profits are not recognized until they are realized, which means that revenue is not recognized unless it is actually received.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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