Realisation principle in 2 Principles and 2 Best Read Cases

The Realisation Principle

The realisation principle is the concept that revenue can only be recognised once the underlying goods or services associated with the revenue have been delivered or rendered, respectively, or risk and rewards are transferred. Thus, revenue can only be recognised after it has been earned. The realisation principle is an application of accrual accounting concept towards the recognition of revenue (income). It is also an application of the prudence principle, i.e. income is revenue is to be recognized only when it is earned, or it becomes reasonably certain that the company will receive the payment from its customer where this revenue is realized when risk and rewards are transferred, or income is due.

In case of sale of goods, revenue must be recognised when the seller transfers the risks and rewards associated with the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which is subsequently settled upon the receipt of the due amount from the customer.Revenue recognition concepts

2 Revenue recognition concepts

In case of the rendering of services, revenue recognition is dependent on the contents of the contract with the customer:

  1. Revenue recognition over time: Revenue is recognised on the basis of stage of completion of the services specified in the contract. Any receipts from the customer in excess or short of the revenue recognized in accordance with the stage of completion are accounted for as prepaid income or accrued income as appropriate.
  2. Revenue recognition at a point in time: If the contract arrangements do not permit revenue to be recognised progressively, then revenue is recognised at a specific point in time on transfer of control of the service.
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Application of the realization principle ensures that the reported performance of an entity, as evidenced from the income statement, reflects the true extent of revenue earned during a period rather than the cash inflows generated during a period which can otherwise be gauged from the cash flow statement. Recognition of revenue on cash basis may not present a consistent basis for evaluating the performance of a company over several accounting periods due to the potential volatility in cash flows.

Cash receipt versus revenue recognition

As such the realization principle does not associate with the receipt of cash from a customer on the bank-account of an entity. The best way to understand the realisation principle is through the following examples:Realisation principle

  • Advance payment for goods. A customer pays $1,000 in advance for a customer-designed product. The seller does not realise the $1,000 of revenue until its work on the product is complete. Consequently, the $1,000 is initially recorded as a liability (in the unearned revenue account), which is then shifted to revenue only after the product has shipped.
  • Advance payment for services. A customer pays $6,000 in advance for a full year of software support. The software provider does not realise the $6,000 of revenue until it has performed work on the product. This can be defined as the passage of time, so the software provider could initially record the entire $6,000 as a liability (in the unearned revenue account) and then shift $500 of it per month to revenue.
  • Delayed payments. A seller ships goods to a customer on credit, and bills the customer $2,000 for the goods. The seller has realised the entire $2,000 as soon as the shipment has been completed, since there are no additional earning activities to complete. The delayed payment is a financing issue that is unrelated to the realisation of revenues.
  • Multiple deliveries. A seller enters into a sale contract under which it sells an airplane to an airline, plus one year of engine maintenance and initial pilot training, for $25 million. In this case, the seller must allocate the price among the three components of the sale, and realises revenue as each one is completed. Thus, it probably realises all of the revenue associated with the airplane upon delivery, while realisation of the training and maintenance components will be delayed until earned.
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The realisation principle is most often violated when a company wants to accelerate the recognition of revenue, and so books revenues in advance of all related earning activities being completed.

Some simple examples

Case #1 – Entity A received EUR 20,00 om 23 February 20×1 as an advance against the goods that are to be purchased on 02 April 20×1 amounting to EUR 30,000. Goods are delivered on 05 April 20×1. State when revenue is to be said to be realized as per the realization principle?

Solution – As per the realization principle, in case of goods, revenue is to be recognized only when the risk and rewards are transferred concerning an underlying asset where risk and rewards are said to be transferred when the goods are delivered, or seller accepted his responsibility of the goods in case of damage or destroy at buyer place.

In the above case, the goods are delivered on 05 April 20×1. So, the revenue is said to be realized on 05 April 20×1. Hence sales are to be recorded on 05 April 20×1 and not on 23 February 20×1. Realization principle does not deal with the receipt of amount.

– As per the realization principle, in case of goods, revenue is to be recognized only when the risk and rewards are transferred concerning an underlying asset where risk and rewards are said to be transferred when the goods are delivered, or seller accepted his responsibility of the goods in case of damage or destroy at buyer place.

In the above case, the goods are delivered on 05 April 20×1. So, the revenue is said to be realized on 05-04-2020. Hence sales are to be recorded on 05 April 20×1 and not on 23 February 20×1. Realization principle does not deal with the receipt of amount.

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Case #2 – XYX Truck Factory Co. Ltd. sells trucks to its sole dealer and enters into a contract for delivering the truck to the customers along with maintenance for one year. State how revenue is to be recognized as per the recognition principle?

Solution – As per the recognition principle, in the case of goods, revenue is to be recognized when all the risk and rewards related to the underlying asset is transferred.

In the case of services or investment, it is to be recognized when income is accrued.

In the case of continuous services, it is to be recognized on a percentage completion basis.

In the above case, the sale of truck is related to the sale of goods and maintenance contract is the continuous service which is to be provided to the customer for one year period.

So according to the recognition principle, the revenue of trucks is to be recognized when risk and rewards related to the truck are transferred, or truck is delivered whichever is earlier.

In case of a maintenance contract, revenue is to be recognized on percentage completion basis, i.e. out of total trucks sold, only the trucks for which warranty period is completed, i.e., the service contract expired are to be recognized.

Also read: WalllStreetmojo

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