Realization concept in accounting

What is the realization concept in Accounting

ACCOUNTING

Realization concept in Accounting-By this post, we shall study in detail the important Realization concept out of 12 various accounting concepts on which accounting is based. If you have a business and record some assets in your financial books then you should know about these important Realization concepts.

What is the Realization concept?

The realization concept is a concept that states the revenue can only be recognized after it has been earned. In simple words, revenue can only be calculated once the underlying goods or services associated with the revenue have been delivered or rendered, respectively.

How can you explain the Realization concept?

The realization concept closely follows the cost concept. Any change in the value of an asset is to be recorded only when the business realizes it. When an asset is recorded at its historical cost of 10,00,000₹ and even if its current cost is 30,00,000₹ such change is not counted unless there is a certainty that such change will materialize.

However, accountants follow a more conservative path. They try to cover all probable losses but do not count any probable gain. That is to say if accountants anticipate a decrease in value they count it, but if there is an increase in value they ignore it until it is realized. Economists are highly critical of the realization concept. According to them, this concept creates value misrepresentation and makes accounting meaningless.

Example of Realization concept?

Example 1: Mr. Love purchased a  piece of land on 1.1.1993  paying  4,000₹. Its current market value  is 2,04,000₹ on 31.12.2022. Should the accountant show the land at 4,000₹ following the cost concept and by ignoring the 2,00,000₹ value increase since it is not realized? If he does so, the financial position would be:

LiabilitiesAmountAssetAmount
Capital4,000₹Land4,000₹
Total4,000₹Total4,000₹

Is it not proper to show it in the following manner?

LiabilitiesAmountAssetAmount
Capital 4,000₹ Land2,04,000₹
Unrealized Gain2,00,000₹
Total2,04,000₹Total2,04,000₹

Nowadays the revaluation of assets has become a widely accepted practice when the change in value is of permanent nature. Accountants adjust such value change through the creation of revaluation (capital) reserve. Thus the going concern concept cost concept, and realization concept gives the valuation criteria.

Example 2: Mr. Ravi received 20,000₹ on 24-03-2022 as an advance against the goods that are to be purchased on 03-04-2022 amounting to 30,000₹. Goods are delivered on 06-04-2022. State when revenue is to be said to be realized as per the realization principle?

As per the Realization concept, in the case of goods, revenue is to be recognized only when the risk and rewards are transferred or the seller accepted his responsibility for the goods in case of damage or destruction at the buyer’s place.

In example 2, the goods are delivered on 06-04-2022. So, the revenue is said to be realized on 06-04-2022. Hence sales are to be recorded on 06-04-2022 and not on 24-3-2022. The realization concept does not deal with the receipt of the amount.

How does the Realization concept work?

We will consider an example to know the work of Realization concept-

For example, Titu Ltd. sells buses to its sole dealer and enters into a contract for delivering the bus to the customers along with maintenance for one year. State how revenue is to be recognized as per the Realization concept?

As per the Realization concept, in the case of goods, revenue is to be recognized only when the risk and rewards are transferred or the seller accepted his responsibility for the goods in case of damage or destruction at the buyer’s place.

In this case, the sale of a bus is related to the sale of goods, and a maintenance contract is a continuous service that is to be provided to the customer for one year period.

So according to the realization concept, the revenue of the bus is to be recognized when risk and rewards related to the bus are transferred, or the bus is delivered whichever is earlier.

In the case of a maintenance contract, revenue is to be recognized on a percentage completion basis, that is out of total buses sold, only the buses for which warranty period is completed, the service contract expired are to be recognized.

What is the importance of the Realization concepts?

  1. True revenue earned during the year is given importance and recognition instead of a collection of revenue.
  2. The risk can be minimized through the realization concept after delivery of the goods.
  3. It ensures recognition consistently.
  4. And it provides a solution for all types of revenue recognition based on the type of revenue.
  5. It gives importance to legal ownership which is acceptable and enforceable by law.
  6. It ensures a true and fair view of the accounts as profit is to be realized and recognized only when the seller transfers risk and rewards.

Faqs related to Realization concepts

  1. What do you mean by the Realization concept?

    According to this concept, revenue is to be recognized only when it is earned, or it becomes reasonably certain that the company will receive the payment from its customer where this revenue is realized when risk and rewards are transferred, or income is due.

  2. What does realization mean in business?

    The realization concept of Accounting defines the point in time when revenues are earned under this premise, whereas profits are not recognized until they are realized, which means that revenue is not recognized unless it is actually received.

  3. What are the advantages of the Realization concept?

    These are the advantages of the Realization concept-
    1. The true and fair view is better reflected in the realization concept.
    2. It guides in the accounting process and recognition of revenue.
    3. Realization concept gives more importance to the recognition of revenue.
    4. Through realization concepts, the inflation of revenue and profits can be controlled.
    5. better consistency.

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