The realisation principle is the concept that revenue can only be recognised in the event that the underlying services or goods associated with the revenue have already been delivered or rendered, respectively. Thus, revenue is only suitable to be acknowledged once it has been fully earned.
Some easy ways to make sense of the realisation principle is by considering the following examples:
- Advance payment for goods. A consumer pays £2,000 in advance for a customer-designed product. The retailer doesn’t realise the £2,000 of revenue until their work on the item is complete. Consequently, the £2,000 is initially noted as a liability (in the unearned revenue account), and is only moved to revenue once the item has shipped.
- Advance payment for services. A consumer pays £12,000 upfront for a 12 months of computer software support. The software company can’t realise £12,000 of revenue upfront; because this service hasn’t been provided as of yet. This particular example is subject to the passage of time. In this instance the software provider may initially record the entire £12,000 as a liability (in the unearned revenue account) and only reallocate £1000 of the total sum to revenue with each passing month.
- Delayed payments. A vendor delivers products to a consumer on credit, and charges the consumer £3,000 for the goods. The vendor is able to realise the entire £3,000 the moment the delivery has been completed, provided there are no further earning activities to perform. The deferred payment is a financing issue that’s not related to the realisation of revenues.
- Multiple deliveries. A vendor enters into a sale contract to which it sells an aircraft to an commercial airline, alongside one full year of engine re-servicing and preliminary pilot training, for £30 million. In this instance, the vendor must allot the value among the three elements of the sale, and realises revenue as each is completed. Thus, in all probability it will realise all the revenue associated with the air plane upon delivery, while realisation of the training and servicing components will likely be delayed until earned.
The realisation principle is frequently violated when a company desires to accelerate the recognition of revenue, and thus books revenues prior to all associated earning activities being concluded.
Auditors focus on this principle when deciding whether or not the revenues booked by a client are valid.