realisation

7.1 Accounting Principles – Realisation (Revenue Recognition)

Objective

• Explain when revenue is recognised under the realisation principle.
• Show the effect on the Income Statement and the Statement of Financial Position.
• Link the realisation principle to the other fundamental accounting concepts in the IGCSE/A‑Level syllabus.
• Apply the principle to typical exam scenarios (AO1 – recall, AO2 – application, AO3 – analysis/evaluation).

Syllabus Mapping (Cambridge IGCSE/AS & A Level)

Section	Content	Assessment Objective(s)
7.1	Realisation (revenue‑recognition) principle	AO1 – state the principle; AO2 – record journal entries; AO3 – evaluate impact on profit measurement
7.2–7.9	Other accounting principles (accrual, matching, prudence, consistency, going‑concern, materiality, comparability, completeness)	AO1 – identify each principle; AO3 – discuss why they are needed together
7.10	Policy‑selection criteria (relevance, reliability, comparability, understandability)	AO3 – evaluate a chosen accounting policy

1. The Realisation Principle

The realisation principle (sometimes called the revenue‑recognition principle) requires that revenue be recorded when it is earned, not merely when cash is received. This ensures the Income Statement reflects the true performance of the business for the reporting period.

2. Relationship with the Other Accounting Principles

Understanding how the realisation principle interacts with the other seven principles helps candidates answer AO3 questions.

• Accrual basis accounting – Revenue is recognised when earned; expenses when incurred, regardless of cash flows.
• Matching principle – The expenses that generate the recognised revenue must be matched to the same period.
• Prudence (conservatism) – Revenue is not recognised before the realisation test is satisfied, preventing profit over‑statement.
• Consistency – The same method of recognising revenue must be applied from one period to the next.
• Going‑concern – Revenue is measured assuming the entity will continue to operate; no need to recognise revenue if the business is about to be liquidated.
• Materiality – Small, immaterial sales may be omitted, but the realisation test still applies.
• Comparability – Using the same realisation criteria each period enables users to compare performance.
• Completeness – All transactions that meet the realisation criteria must be recorded, even if the records are incomplete.

3. When Is Revenue Realised?

Revenue is recognised only when all of the following conditions are met:

1. The goods have been delivered or the service has been performed.
2. Ownership (or the risks and rewards of ownership) has passed to the customer.
3. The amount of revenue can be measured **reliably**.
4. It is probable that the economic benefits will flow to the entity.

Example – Measurement reliability

A furniture maker receives an order for a custom sofa. The price is not fixed until the design is approved. Revenue cannot be recognised until the sofa is delivered and the final price is agreed, because the amount is not yet measurable with reasonable certainty.

4. Situations Where Realisation Is Deferred

Cash receipts do not always lead to immediate revenue recognition. The following are typical IGCSE‑level examples:

• Subscriptions or service contracts – Cash received for a 3‑month magazine subscription is recorded as Unearned revenue and recognised each month.
• Long‑term contracts (e.g., construction) – Revenue is recognised only when the contract is completed (IGCSE). (A‑Level students may also use the percentage‑of‑completion method.)
• Installment sales – Goods are delivered, revenue is recognised at delivery; the instalments create a receivable.
• Advance payments for insurance, rent, advertising – Treated as unearned revenue until the service period elapses.

5. Unearned Revenue (Deferred Revenue)

Cash received **before** the revenue criteria are satisfied is recorded as a liability called Unearned revenue. It is transferred to revenue only when the related goods or services are delivered, satisfying the realisation test. This reflects the prudence principle – profit is not overstated.

6. Journal Entries Illustrating Realisation

Transaction	Debit	Credit	Explanation
Sale of goods on credit (goods delivered)	Accounts Receivable $5,000	Sales Revenue $5,000	Revenue recognised because delivery and transfer of ownership have occurred.
Cash received for a service performed earlier	Cash $2,000	Accounts Receivable $2,000	Revenue was already recognised when the service was performed; this entry only settles the receivable.
Cash received in advance for a 3‑month subscription	Cash $1,200	Unearned Revenue $1,200	Liability recorded because the service has not yet been provided.
One month of the subscription earned	Unearned Revenue $400	Subscription Revenue $400	Revenue recognised as the service is delivered (matching one month of income).
Completion of a 6‑month construction contract (total price $12,000)	Accounts Receivable $12,000	Construction Revenue $12,000	Revenue recognised only after the contract is finished (full realisation).

7. Worked Example – Effect on the Financial Statements

Company X makes a $6,000 sale on 1 January, delivers the goods on that date, and receives cash on 15 January.

7.1 Before any entry (31 December previous year)

Income Statement
Revenue	—
Expenses	—
Profit	—
Statement of Financial Position
Assets	—
Liabilities	—
Equity	—

7.2 After recognising revenue on 1 January (realisation) but before cash receipt

Income Statement (January)
Revenue	$6,000
Cost of Goods Sold	$3,600
Profit	$2,400
Statement of Financial Position (31 January)
Assets	Accounts Receivable $6,000
Liabilities	—
Equity	Retained profit $2,400 (plus opening equity)

7.3 After cash is received on 15 January

Statement of Financial Position (15 January)
Assets	Cash $6,000 (instead of Accounts Receivable)
Liabilities	—
Equity	Unchanged – profit already recorded.

This sequence shows that the realisation principle moves revenue from “not yet recorded” to “recognised”; the later cash receipt only changes the composition of assets, not profit.

8. Impact on the Financial Statements (Summary)

• Income Statement – Only revenue that meets the realisation criteria is shown, giving a realistic profit figure.
• Statement of Financial Position
  • Accounts receivable appears when revenue is earned on credit.
  • Unearned revenue appears as a liability until the related service/goods are delivered.

9. Incomplete Records Reminder (AO2)

If a business keeps only partial records (e.g., cash book without a sales ledger), the examiner expects you to:

1. Identify the information given (delivery dates, contract terms, payment status).
2. Apply the four‑point realisation test.
3. Record the appropriate journal entry or state why no entry can be made.

10. Common Mistakes (Exam Traps)

Trap	Why it’s wrong	Correct approach
Recording revenue when cash is received before the service is performed.	Violates the prudence and realisation principles – profit is overstated.	Debit Cash, credit Unearned Revenue; recognise revenue later.
Leaving the amount in Unearned Revenue after the service has been delivered.	Fails the matching principle – expenses are matched but revenue is not.	Transfer the appropriate portion to Revenue each period.
Recognising revenue for goods that have been invoiced but not shipped.	Ownership (risks and rewards) has not passed.	Wait until delivery before recording Sales Revenue.
Omitting the measurement‑reliability test when the price is uncertain.	Revenue amount cannot be measured reliably.	Delay recognition until the amount is fixed.
Confusing the cash‑receipt entry (debit Cash / credit Accounts Receivable) with a revenue‑recognition entry.	Cash receipt may settle a receivable; revenue may already have been recorded.	Check whether the realisation test was satisfied earlier.

11. Revision Checklist – Has Revenue Been Realised?

1. Have the goods been delivered or the service performed?
2. Has ownership (or the risks and rewards) passed to the customer?
3. Is the amount measurable with reasonable certainty?
4. Is it probable that the economic benefits will flow to the entity?
5. If cash was received in advance, has it been recorded as Unearned revenue?

12. Practice Questions (AO1–AO3)

Question 1 – AO1 & AO2

Scenario: On 1 February, Alpha Ltd receives $4,800 in cash for a 12‑month insurance policy that starts on that date. Prepare the journal entries for (a) 1 February and (b) 31 July (after six months).

Answer:

(a) 1 February
Debit   Cash                         $4,800
Credit  Unearned Revenue – Insurance $4,800
   (Cash received in advance; revenue not yet earned)

(b) 31 July
Debit   Unearned Revenue – Insurance $2,400
Credit  Insurance Revenue               $2,400
   (Recognition of six months’ insurance: $4,800 ÷ 12 × 6)

Question 2 – AO2 (Journal entry with partial records)

Beta Co. keeps only a cash book. The cash book shows a receipt of $2,500 on 10 March labelled “Advance – magazine subscription (3 months)”. No other records are available. Show the journal entry that must be made on 10 March and explain why.

Answer:

Debit   Cash                         $2,500
Credit  Unearned Revenue – Subscription $2,500
   (Cash received before the service period; revenue cannot be recognised until each month’s magazine is delivered.)

Question 3 – AO3 (Analysis & Evaluation)

Discuss the advantages and disadvantages of recognising revenue on a percentage‑of‑completion basis for a long‑term construction contract, compared with recognising revenue only on contract completion. Use the realisation principle in your argument.

Suggested points for an answer:

• Advantages of percentage‑of‑completion
  • Provides a more timely picture of profit; aligns with the matching principle.
  • Better for users of financial statements who need interim performance information.
  • Reduces large fluctuations in profit from period to period.
• Disadvantages
  • Requires reliable estimates of total contract costs and stage of completion – may breach the measurement‑reliability test.
  • Higher risk of manipulation (over‑estimating progress to boost profit).
  • More complex accounting records; not required at IGCSE level.
• Recognition on completion only
  • Simple and complies strictly with the realisation test (revenue recognised when risks and rewards have fully transferred).
  • May give a misleading view of performance in long projects – profit appears only at the end.
• Conclude by stating that the choice of policy must satisfy the policy‑selection criteria (relevance, reliability, understandability) and be applied consistently.

13. Diagram – Timeline for Unearned Revenue (optional for revision)