The accrual-based accounting model requires that revenue be recognized in the period in which it is earned. This will not always correspond with the period in which it is collected. Accounting principles, such as the realization principle, help ensure that revenue is recognized in the appropriate reporting period. The realization principle establishes guidelines to determine appropriate recognition criteria for a given operating model.
Under the accrual-based accounting method, revenues are recognized when earned and expenses are recognized when incurred. This is in contrast to a cash basis system, in which revenue is recognized when collected and expenses recognized when paid. Accrual-based financial statements more adequately reflect the financial performance and position of a company. This allow users to evaluate a company’s accomplishments during an accounting period without consideration of when cash is received or paid.
The realization principle, also known as the revenue recognition principle, requires that two criteria be satisfied before a company can include revenue on its income statement. First, the company must have substantially completed the earnings process. Second, the company must have a reasonable certainty that the receivable can be collected. The realization principle ensures that the revenue is not recorded until a company has performed all or most of its earning activities and that the buyer that is capable of paying for the goods or services.
Completion of the Earnings Process
The earnings process is typically considered complete when the goods or services are delivered. This can vary by industry and business. For instance, a brick-and-mortar retailer may complete its earnings cycle at the cash register, whereas an online retailer may recognize revenue when it ships the product to the customer. Construction contractors, on the other hand, recognize revenue based on the percentage of each project that completed during the current reporting period.
Collectability of the Asset
There must be a reasonable assurance that the party receiving the goods or services has the ability to pay for them. When revenue is recognized before cash is received, a receivable is recorded on the balance sheet. If there is doubt as to its collectibility, the company must remove it from the balance sheet or offset it with an allowance for uncollectable accounts. For this reason, revenue cannot be realized and a receivable cannot be reported unless there is a reason to believe the party is willing and able to pay for the goods or services.