Realization Concept
In this article, we are
going to discuss what is the realization concept?
You should first know
that there is a group of rules of accounting. They are well known to many as accounting concepts. These concepts and rules are essential when preparing
the final accounts of an entity. Even to some extent the accounting concepts
also assist to make the final accounts relevant and reliable to its users.
In all, there are ten
main accounting concepts, of which we will look at the realization concept.
The realization concept
states that transactions of a business are recorded in the accounts when the
legal title passes between the buyer and seller. The concept is heavily
associated with the selling of goods and services, the respective revenue must
be recognized or realized when the seller transfers the risks and rewards i.e.
the legal title associated with the ownership of the goods to the buyer. In
most cases, the legal title transfer occurs at the time when the goods are
actually handed over to the buyer. However,
sometimes the legal title transfer may not be at the
same time as the payment is made. For example, where goods and services are
sold on credit they are recorded when it is made but the payment will be made
at a later date.
Let’s give an example to
illustrate the concept. Fairway Ltd is a golf equipment retailer. One of its
loyal customers, Tim, decided to order a set of custom made golf irons, worth
£2,000. Due to the irons being custom made, Tim will receive them in one
months’ time and it has been agreed that 50% will be paid by Tim at the time of
ordering the set and the other 50% will be paid in a months’ time once he has
received them. When should the revenue be recorded in the accounts?
By applying the
realization concept Fairway Ltd should not record or realize any revenue of
when the golfing irons were initially ordered. Subsequently, the full £2,000
revenue will only be recorded in the accounts of Fairway Ltd once the golf
irons have been distributed to Tim the customer. This is because it is at this
point when the risks and rewards related to the ownership of the golf irons are
transferred to the buyer or Tim.
So that was the
definition of the realization concept.
Substance over Form Concept
Substance over form is
an accounting principle used to ensure that financial statements give a
complete relevant and
accurate picture of
transactions and events, if an entity practices the substance over form concept
then the financial statements will show the overall financial reality of the
entity economic substance rather than the legal form of transactions form in
accounting for business transactions and other events the measurement and reporting
is for the economic impact of an event instead of its legal form substance over the form is critical for reliable financial reporting it is particularly relevant
in cases of revenue recognition sale and purchase
agreements etc the key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent
of the transaction which would mislead the readers of a company's financial
statements following our examples of the application of the concept.
In the international financial reporting standards AFER's IAS 17 leases require the 25 preparers of financial statements to consider the substance of lease arrangements when determining the type of lease for accounting purposes for example an asset may be leased to see without the transfer of legal title at the end of the lease a term such a lease may in substance be considered as a finance lease for instance the lease term is substantially for the entire useful life of the asset or the lease agreement entitles the lessee to purchase the asset at the end of the lease term at a very nominal price and it is very likely that such an option will be exercised by the lessee in the given circumstances a lease might not transfer ownership of the leased property to the lessee in some circumstances the lessee might nevertheless be required to record the leased item as an asset if the lessee intends to use the asset for a major portion of its useful life or where the present value of the future lease payments is nearly equal to the fair value of the asset although the lessee is not the owner the lessee may be required to record the asset as being owned by the lessee based on the underlying economics of the transaction, another example is the situation where a company short of cash sells its machinery to the bank and then leases the same property from the bank this arrangement is called sale and leaseback although the legal ownership has been transferred to the bank the underlying economic reality for the company remained the same under the substance over form principle the sale and subsequently, SPAC is considered one transaction similarly if two companies swap their inventories this event is not accounted as a sale because the substance is a mere in-kind exchange despite the possible form of valid enforceable contracts for two sells and deliveries likewise a firm withdrawing inventory for internal use accounts, this event in a separate account classified as such and not on the sale account the principal fast maintains the sales account as reflecting only actual sales in substance that is items delivered to outside parties for payment and not events that merely fit the form of sales documentation for convenience or expedience, the principle strictly governs and resolves disputes of whether workers are independent contractors or employees tax law forbids accounting for persons who are substantially employees in the form of independent contractors the question of which form may be applied to any given case submits to objective tests of the substance of the work hence substance over form is the rule.
