Realization concept explained

The realization concept focuses on the recognition of revenue in the statement of profit or loss and the books of accounts. This recognition is based on industrial norms. Therefore, the periods of revenue recognized are not the same in all industries.

1. What's realization concept

The realization principle states that revenue is recognized when it reaches the consumer and the service is accomplished. However, the time when this recognition occurs is different from industry to industry. The industrial norms must be considered in determining the recognition of income in the profit or loss statement.

Generally, goods are recognized in those statements when the title or possession passes to the buyer and not necessarily when the entity receives payments for them. Also, income from a service rendered by an entity is recognized in the book of account when the service is done.

The way contractors of building and other infrastructure recognize revenue is different from that of a leasing company. Also, the way a hospital realizes income from their patient is dissimilar from a software company. The accountant must consider the norms of the industry. Therefore, he or she must familiarize himself or herself with the industry.

2. Applying the realization concept

The IFRS 15 Revenue from contract with customers explained when income should be realized by a business using five recognition principles referred to as the five step model in ICAN study pack on financial reporting. These includes:

Identify the contract(s) with the customer
Identify the separate performance obligations
Determine the transaction price
Allocate the transaction price to the performance obligations
Recognise revenue when or as an entity satisfies performance obligations

From the foregoing, it's clear that for an entity to realize revenue, it must separate the performance obligation and include a price tag on each of them. This implies that if there is a single performance obligation to the customer or client then revenue is recognized once. However, multiple obligations will be required at separate times to recognize revenue, though the cash may have been received in full.

For example, a web hosting company may receive payment for web hosting for a full year in a single month, say in May 2023. According to the recognition principles, the entity will have to spread the revenue over 1 month. That is, from May 2023 to April 2024. In addition, such companies may receive income from both web hosting and domain name. It shouldn't put all the money in one basket. This must be separated since they are different performance obligations.

3. Differences between realization and matching concept

Realization and matching concepts are not the same concept and they are only related to the extent to which revenue is recognized in the profit or loss statement. Matching concept is a broader principle compared to the realization concept. While the latter focuses on revenue, the latter is about revenue and expenses.

In realizing revenue,only those relating to a particular period in which the profit statement is prepared are recognized. This is to ensure that relevant expenses are matched with the right income. Thereby, enhancing the accuracy of the report.