Before we can talk of realization or recognition, we need to understand what an accounting event is.
An event is a transaction that alters an entity’s financial statement.
An event causes a change in either the assets, liabilities or equity section of the balance sheet.
A transaction is an event that involves the transfer of value between two parties. An example of a transaction is borrowing money from a bank. The exchange of cash for debt causes an accounting event to take place: both the assets and liabilities of the business entity will increase as a result.
As an accountant, it is part of your job to know when an accounting event has taken place. Some events are very obvious for example exchanging cash for a product or service. And some events are less obvious like an uninsured business loss from flood damage, losing a lawsuit, etc. These events are often missed in financial reporting because they do not involve an immediate outlay of cash but however, sometime in the future cash will need to be paid to cover the losses. Any event that has an economic effect on the assets, liabilities or equity must be recorded.
When you think of the word recognize, what comes into mind. According to Merriam Webster dictionary, to recognize something means to acknowledge formally. In accounting, recognition means to formally report an event in the financial statements. Just because we recognized an event does not mean cash exchanged hand. For example, Uncle Joe buys a cup of lemonade from you, Uncle Joe says he has no money to pay you at the time but he promises he will pay next week when he comes back to visit. Uncle Joe buying lemonade from you is a recognized event even though no cash was exchanged.
In a business, it is important to differentiate between the events that actually happen in the business and the cash collected in the business. Events are good predictors of future cash flow but the occurrence of an event does not always correspond with the collection of cash.
On the other hand when we realize an event we convert the event into actual cash. Let us say you approach Uncle Joe and tell him you a starting a lemonade stand. Uncle Joe thinks your idea is so cool and places an order for 10 cups of lemonade even before you open shop. In this case, the cash was received before the event. In other words, we realized an event before we recognize it. The recognition of the event does not happen until the actual event takes place. Uncle Joe is paying for a future transaction.
Can you think of other examples?
In accounting, the realization conversion states that the revenue should only be recognized when realized. Realization occurs when:
- The activities necessary to generate the revenue are substantially complete. Example – an accountant filing a tax return
- The amount of revenue generated can be objectively determined
- There is reason to believe that the amount owed from the activity will be collected.
The realization principle in accounting means that revenue is recognized before cash is received. This means that revenue on the profit and loss statement will include revenue from transactions where cash has not being received. This translates to total revenue and cash from operations will not match. When this happens we call this the accrual basis of accounting. Accrual basis of accounting is the generally accepted accounting principle (GAAP).
The opposite of accrual basis accounting is cash basis accounting. In cash basis accounting, transactions are only recorded when cash exchanges hand. This is used by very small businesses for easy record keeping.