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. 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.
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.
In case of the rendering of services, revenue recognition is dependent on the contents of the contract with the customer:
- 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.
- 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.
|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.|
The best way to understand the realisation principle is through the following examples:
- 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.
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.
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