Realization PrincipleDefined along with Examples

Written By:
Lisa Borga

The realization principle is a concept in accounting that states that revenue should be recognized once it is earned.

This is the point at which a business can reasonably expect that the customer will pay for the goods or services.

Typically, this will happen when the business has rendered the services or transferred the goods to the customer.

The revenue should be recognized at this point whether or not the payment has actually been received.

Understanding the Realization Principle

The realization principle explains when revenue should be recognized.

Businesses should recognize revenue when they transfer the goods that have been purchased to the customer or the point at which the risks and rewards of ownership are transferred from the seller to the buyer.

If the transaction involves income, the revenue should be recognized at the time the income is due.

When a continuous service business is dealing with revenue, the revenue should be recognized by using the percentage completion method.

When using this concept, a business will recognize revenue at the point it is earned or when the business can reasonably expect that it will obtain payment from the customer, and the revenue is only realized when the seller transfers the risk and rewards of the transaction to the buyer or when the income is due.

According to the realization principle, recognition of revenue does not depend on cash being received.

Revenue or income should be recognized when it is earned, whether the cash has been received or not.

This means if a business receives an advance, and they have not yet delivered or transferred the goods, the revenue should not be recognized.

The revenue should be recognized once the business does transfer the goods.

Example One

Suppose a business sold some goods on account for $20,000 on August 15, 2021.

This business received an advance of $10,000 on the purchase on September 15, 2021.

The goods were delivered on October 15, 2021.

We will now explain when the business should recognize the revenue for this transaction.

According to the realization principle, when goods are involved, the revenue is recognized when the risks and rewards of ownership are transferred to the buyer or when the seller takes responsibility for goods that have been damaged or destroyed.

In this example, the seller delivered the goods on October 15, 2021.

Therefore, the business should recognize the revenue on October 15, 2021.

Additionally, the sale should be recorded on October 15, 2021, rather than September 15, 2021.

Example Two

Plants and More agrees to maintain the plants at Ben’s Burgers and signs a contract to do this for a year.

We will show how the business should recognize the revenue while following the realization principle.

The realization principle states that when a business sells goods, the revenue will be recognized at the time the seller transfers the risk and rewards of owning the goods to the buyer.

When services or investments are involved, the revenue will be recognized at the time the income is accrued.

However, if the service is continuous, then the business will recognize the revenue based on the percentage completion method.

So in the case of Plants and More, since they will be providing service to Ben’s Burgers continuously for a year, the revenue will be recognized using the percentage completion method.

This means that Plants and More would recognize the percentage of total income that would match the percentage of the total job that has been completed.

Importance

The realization principle gives an accurate view of a business’s profits by ensuring that income is not recognized until the risk and rewards have been transferred.

This principle allows the revenue actually earned during a year to be recognized instead of only what is collected.

It also ensures that revenue is recognized in a consistent manner.

Additionally, it recognizes the importance of legal ownership in a transaction that can be legally enforced.

Advantages of the Realization Principle

There are several advantages to the realization principle, including:

• It helps give an accurate view of a business’s finances.
• It helps allow a business to control the inflation of profits and revenue.
• It stresses the importance of recognizing revenue versus collecting revenue.
• This principle is commonly followed when businesses use the accrual method of accounting.