The realization principle is the concept that revenue can only be recognized once the underlying goods or services associated with the revenue have been delivered or rendered, respectively. Thus, revenue can only be recognized after it has been earned. The best way to understand the realization principle is through the following examples:
- Advance payment for goods. A customer pays $1,000 in advance for a customer-designed product. The seller does not realize the $1,000 of revenue until its work on the product is complete. Consequently, the $1,000 is initially recorded as a liability (in the unearned revenue account), which is then shifted to revenue only after the product has shipped.
- Advance payment for services. A customer pays $6,000 in advance for a full year of software support. The software provider does not realize the $6,000 of revenue until it has performed work on the product. This can be defined as the passage of time, so the software provider could initially record the entire $6,000 as a liability (in the unearned revenue account) and then shift $500 of it per month to revenue.
- Delayed payments. A seller ships goods to a customer on credit, and bills the customer $2,000 for the goods. The seller has realized the entire $2,000 as soon as the shipment has been completed, since there are no additional earning activities to complete. The delayed payment is a financing issue that is unrelated to the realization of revenues.
- Multiple deliveries. A seller enters into a sale contract under which it sells an airplane to an airline, plus one year of engine maintenance and initial pilot training, for $25 million. In this case, the seller must allocate the price among the three components of the sale, and realizes revenue as each one is completed. Thus, it probably realizes all of the revenue associated with the airplane upon delivery, while realization of the training and maintenance components will be delayed until earned.
The realization principle is most often violated when a company wants to accelerate the recognition of revenue, and so books revenues in advance of all related earning activities being completed.
Auditors pay close attention to this principle when deciding whether the revenues booked by a client are valid.