Realization Concept (Revenue Recognition Principle)


Definition

Realization concept in accounting, also known as revenue recognition principle, refers to the application of accruals concept towards the recognition of revenue (income). Under this principle, revenue is recognized by the seller when it is earned irrespective of whether cash from the transaction has been received or not.

Explanation

In case of sale of goods, revenue must be recognized 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 is recognized 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.

Example

Motors PLC is a car dealer. It receives orders from customers in advance against 20% down payment. Motors PLC delivers the cars to the respective customers within 30 days upon which it receives the remaining 80% of the list price.

In accordance with the revenue realization principle, Motors PLC must not recognize any revenue until the cars are delivered to the respective customers as that is the point when the risks and rewards incidental to the ownership of the cars are transferred to the buyers.

Importance

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.

Test Your Understanding

Contractors PLC entered into a contract in June 2012 for the construction of a bridge for $10 million. The total costs to complete the project are estimated to be $6 million of which $3 million has been incurred up to 31st December 2012. Contractors PLC received $2 million mobilization advance at the commencement of the project. No further payments have been received.
How much revenue should Contractors PLC recognize in the income statement for the year ended 31st December 2012?

$2 million

$3 million

$5 million