When a seller takes an order or signs a sales contract with a business customer, the seller cannot claim "sales revenues" and "accounts receivable" until (1) the seller has good reason to believe the customer will pay and (2) the seller earns the revenues by delivering goods and services.
For companies that use accrual accounting, revenues from sales of goods and services are said to be realizable revenues by the seller only when there is a good reason to believe the seller will receive payment.
When the customer does pay, or when the buyer provides proof that payment is truly forthcoming, the seller realizes revenues.
By contrast, for companies that use cash basis accounting, the realization concept does not apply. Under cash basis accounting, sellers claim sales revenues only when customers pay in cash.
Explaining Revenue Realization in Context
Sections below further define and explain realization in context with related accounting terms, emphasizing three themes:
- First, the reason that sales revenues must be realizable, in order to claim as earned revenues.
- Second, the role of revenue realization in accrual accounting transactions.
- Third, steps sellers must take when sales revenues are unrealizable.
- What is revenue realization?
- When are revenues realized in accrual accounting?
- Is the realization concept necessary?
Under accrual accounting realizability is one of the two conditions that must exist before the seller can claim incoming sales revenues. The revenue claim impacts two accounts: Firstly, an Income statement Revenue account such as "Sales revenues" and secondly, a Balance sheet Assets account such as "accounts receivable." Sellers can claim revenues for these accounts by meeting these two conditions:
- They believe they will realize (collect) these revenues.
- The seller earns the revenues by delivering goods or services.
Until the seller meets both conditions, sellers carry the revenues in a Liability account such as Unearned Revenues.
Realizing Revenues Before Earning Revenues
Consider, for instance, a computer user buying a one-year subscription to an online backup service. Computer users normally pay for these subscriptions in advance. When the customer submits an advance payment transaction, the service provider realizes revenues, immediately.
Nevertheless, the seller also classifies the same revenues initially as Unearned Revenues, an entry in a Liability account. As the customer uses the service, month by month, the seller will transfer funds from the Liability account to the Revenue account Sales Revenues.
See Unearned Revenues for more on the bookkeeping transactions and accounting reporting of unearned and unrealized revenues.
On first hearing, the realization requirement for claiming receivables may seem somewhat pointless or unnecessary. After all, it is hard to imagine a seller knowingly shipping products, if the seller knows the customer will never pay. There are situations, however, where circumstances move the seller to recognize only after the sale, that the customer is not going to pay.
Recognizing Unrealizability After the Sale
A customer may become dissatisfied with the quality of goods or services ordered and received, but not yet paid for. Or the customer may receive products and simply claim that they were not "as advertised." Customers in such cases sometimes dispute their obligation to pay.
When this occurs, the seller must choose between (1) demanding a return (if the dispute is over merchandise the customer can return), (2) pursuing legal collection activities against the customer, or (3) simply deciding the seller will never realize these funds and recognize that reality with a write off.
Or, as another example, customers may appear solvent at the time of the sale, but then develop an inability to pay. Consider a product sale where the customer buys "on account" (on credit provided by the seller), and where the customer turns out to be a poor credit risk. The customer may, for instance, go out of business or declare bankruptcy before paying.
In either kind of situation, if the seller delivers but does not receive payment for goods and services, and if the seller doubts the buyer will pay, sellers normally still attempt for some time to persuade the buyer to pay (e.g., up to 90 days or 120 days after due date). If the customer still does not pay, and if there is a good reason to believe the customer will never pay, the seller may formally recognize that the funds are not realizable by writing them off as a bad debt expense.