The realization concept states the business should only recognize the revenue when earned. The revenue is earned when goods are delivered to the customer or services are rendered for them.

In other words, the realization concept states revenue should only be recognized when the legal process related to revenue earning has been completed. If the revenue is recorded without completion of the legal process, the realization concept is violated. Similarly, if the revenue is not realized after the completion of the legal process, it’s again a violation of the realization concept. So, what is the legal process?

For goods, the legal process is the dispatch of goods to the customers as it transfers risk and reward to the customer.

For services, the legal process means the service was rendered for the customer.

This concept is often violated when businesses try to window-dress financial statements by inflating revenue, leading to inflated profit and financial performance.

Similarly, this concept can be violated with the motivation to understate profit for reduced income tax liability. For instance, businesses may not record revenue even after the dispatch of goods. This means that the business may be willing to show a reduced profit for paying less tax liability.

Hence, it’s important to ensure compliance with the realization concept for appropriate financial reporting.

Situations when the realization concept is often violated

Advance customer payment– Advance payment received from customers should be classified as deferred income (liability) and not revenue. Recording this payment as revenue will distort the realization concept and lead to artificially escalated revenue and inflated profit.

Multiple deliveries– The business may be required to make multiple deliveries for a single sales invoice. So, suppose the business recognizes a full sales invoice after making a single delivery. In that case, it’s a violation of the realization concept because a full invoice can only be recorded when all dispatches are made to the customer.

The right approach is to record revenue in line with the dispatch. For instance, if 2 dispatches are made, the revenue should be recorded for the value of goods sold in two dispatches and so on. 

Overbilling– The electricity company sends you a bill for the 500 units, but you’ve consumed only 450 units. It means they’ve overbilled you 50 units. Hence, the realization concept was violated, and revenue was recorded as escalated.

Under billing– Similarly, if you’ve consumed 400 units but billed 350 units. It leads to lower revenue and lower profit for the current accounting month. Hence, underbilling also leads to a violation of the realization concept.

There can be different motives behind over and under-billing. For instance, window dressing or escalated financial performance can be the motive behind overbilling. Similarly, saving taxes can be a motive for underbilling and showing underperformance.

Hence, it’s important to ensure that the concept is complied with for appropriate financial reporting. So, the next question is,

How accountants and auditors ensure compliance with the realization concept

Following procedures can help ensure compliance with the realization concept of accounting.

• Ensuring each sales invoice is appropriately backed by dispatch notes.
• Ensure the cut-off concept of accounting is complied with.

Conclusion

The realization concept of accounting refers to ensuring revenue is only recognized/recorded when earned. In other words, It’s s about only recognizing the revenue when the legal process related to revenue recognition is completed.

Generally, the motive behind overstated revenue is to window dress financial statements, which means showing escalated financial performance.

Similarly, the motive behind understated revenue may be to hide profit for paying lower tax liability or even deferring the profit for the next accounting period.

Understating and overstating the revenue violates this concept. So, it’s important to ensure the customer is only billed for the goods delivered to them or services rendered to them.

As part of ensuring compliance with the realization concept, the auditor is required to ensure each sales invoice is backed by delivery notes and transactions not violating the cut-off concept.