Realization Principle of Accounting
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.
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.
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.