Realisation Principle in Revenue Recognition

In this article we will discuss about the realisation principle in revenue recognition.

The realisation principle primarily determines the question of revenue recognition. Revenue recognised under the realisation principle is recorded at the amount received or expected to be received.

The realisation principle requires that revenue be earned before it is recorded. This requirement usually causes no problems because the earning process is usually complete or nearly complete by the time of the required exchange.

McFerland defends realisation principle in recognition of revenue:

“There are strong reasons why revenues reported in the summary income statement by management arid by investors. Since adherence to the realisation concept brings revenues into close conformity with the current inflow of disposable funds from sales, reported profits constitute a reliable measure of a company’s ability to pay dividends, to retire debt, or to increase shareholders equity and future profits by reinvesting earnings. The realisation concept also helps to avoid the possible disastrous consequences which may follow if financial obligations are undertaken in reliance on reported revenues which fail to materialize as disposable funds.”

Realisation, however, cannot take place by the holding of assets or as a result of the production process alone. It is true that increases and decreases in asset values take place prior to sale. However, these are only contingent values since their ultimate validation depends on completion of the entire production and marketing cycle.

Un-realised increases in asset values do not produce any disposable funds for reinvestment in the business or for paying debts and dividends. Consequently, the accountant regards historical cost inputs as invested capital and ordinarily does not recognise changing values until realisation has occurred.

Moreover, the amounts of these un-realised increases can be supported only by circumstantial evidence drawn from transactions to which the company owning the assets is not a party. A wide area for subjective judgements exists in selecting pertinent transactions and the reliability of the measurements of un-realised revenues is likely to be too low to merit the confidence placed in ‘ external financial statements.

According to some writers, revenue realisation and revenue recognition, although sometimes recorded concurrently, are distinct accounting phenomena and distinct occurrences. Revenue realisation occurs at the time of giving of goods or services by the entity in an exchange.

Revenue recognition is the identifying of revenue to be admitted to a given year’s income statement. Most often, revenue realisation and recognition occur contemporaneously and are recorded concurrently, i.e., in the same entry.

However, in some specialised cases, it is possible for revenue recognition to precede or to follow revenue realisation. Hendriksen feels that much confusion prevails because of the realisation concept which seems to predate the critical events giving rise to income.

Hendriksen, therefore, advises to abandon the term (realisation):

“In its (realisation) place, emphasis should be placed on the reporting of valuation changes of all types, although the nature of the change and reliability of the measurement should also be disclosed. Furthermore, accountants may be able to provide more relevant information to users of external reports if less emphasis is placed on the relationship revenue to net income and more emphasis on the informational content of the several measurements of revenue. For example, it is likely that several attributes of revenue—such as sales price of goods produced, goods and services sold, and the final amount of cash received for goods and services rendered—may he relevant to external users. Acceptance of one attribute should not necessarily exclude disclosure of other attributes.”

The American Accounting Associations’ Committee on Concept and Standards has concluded that income should be reported as soon as the level of uncertainty has been reduced to a tolerable level.

The Committee observes:

“Realisation is not a determinant in the concept of income; it only serves as a guide in deciding when events otherwise resolved as being within the concept of income, can be entered in the accounting records in objective terms; that is when the uncertainty has been reduced to an acceptable level.”

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