September 20, 2021

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Realization Principle

Realization Principle

When you sell goods or maybe your business provides services instead, you get paid money which is considered to be your revenue. It is one of the most important aspects of a company’s operations and reporting. In this regard, of course, the financial reporting standards could not ignore the revenue accounting topic, in particular, its recognition.

In accounting, recognition refers to the process of acknowledging and recording a financial transaction in the bookkeeping records and then transferring it to the financial statements as an asset, liability, income, or expense. It is extremely important to decide when the organization’s revenues should be recognized as received. In its most general terms, both GAAP and IAS/IFRS assume that revenues are recognized when they are realized and earned.

Realization Principle

Realization principle

The new accounting standards for revenue recognition came into effect in early 2018 and are nearly identical under IFRS and US GAAP. The realization principle states that the revenue should be added to the accounting book only when it is realized. For this to happen, specific conditions should be met:

  • Legal title transfer from the seller to buyer
  • Risk and reward transfer
  • Product actually being sold.

The realization of income can be viewed as a receipt of income that is confirmed by the existence of an exchange transaction that took place. In other words, revenues are realized when you actually sell the shirt or car or any other good to a customer or perform some type of work, thereby causing either the receipt of money or the right to receive money or other assets.

Under this principle, you would need to have your bookkeeper record the revenue your business generated when it is earned. This means that regardless of when the funds are being transferred and received as a payment, it will be acknowledged and entered into the records as revenue when the good or service has been delivered.

The recognition of the money being paid by the customers can happen in two ways. Either the service will be provided before the reward in the form of cash will be given for the work performed or the worker or business receive the money in advance and then provide the service.

Example

You have a customer order an expensive custom piece of furniture from your business. Knowing that you will be unable to sell custom products to anyone in case the customer rejects to pay for the order and how hard it is to collect money on time, you have a policy that states that customers have to make 100% payment upfront for custom orders.

Your customer pays you $12,000 for the product you will be making for him at the end of October. It takes you almost two months to complete the order and you deliver the piece of furniture to the customer at the beginning of December. Which month should the revenue be recorded in your bookkeeping records? Despite the fact that it might seem that the right answer is October, it is December. This is because your business had not earned this revenue as of October (or November for that matter). This is a good example of deferred revenue because the cash was paid prior to the completion of the order.

Let’s consider a case where the customer agrees to pay only when he sees the final product. Accordingly, you do not get anything in October, but still proceed with the creation of custom furniture. When you finish in December and the customer is satisfied with the result, you record revenue when you deliver the furniture to the buyer. In both cases, your business adheres to the realization principle.

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Author: Charles Lutwidge

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