What is the Realization Convention?
The realization convention is a fundamental principle in accounting that dictates how and when changes in the market values of assets and liabilities should be recognized in financial statements. Specifically, under the realization convention, increases or decreases in the market values of assets and liabilities are not recognized as gains or losses until the assets are sold, or the liabilities are paid. This approach aligns with the historical-cost accounting method, where assets are recorded at their original purchase price.
Examples
Example 1: Asset Appreciation
Imagine a company that purchased a piece of machinery for $50,000. Over time, the market value of this machinery increases to $60,000. Under the realization convention, the company would not recognize the $10,000 increase in value on its financial statements until the machinery is actually sold.
Example 2: Asset Depreciation
Consider a business that bought a piece of real estate for $200,000. If the market value of this property decreases to $180,000, the $20,000 loss is not recorded in the financial statements until the property is sold at the reduced price.
Example 3: Liability Settlement
A company has a liability of $100,000. Due to favorable market conditions, the cost to settle this liability reduces to $80,000. However, under the realization convention, the $20,000 gain is not recognized until the liability is actually settled.
Frequently Asked Questions
What is the primary benefit of the realization convention?
The primary benefit is that it provides more accurate historical cost information, thus avoiding fluctuations in financial statements due to volatile market conditions and unverified valuations.
Why is the realization convention important in accounting?
It ensures that only realized gains and losses, those that have been confirmed through transactions, are recorded in financial statements. This prevents speculative market changes from affecting financial reports.
Can the realization convention lead to conservative financial reporting?
Yes, as gains are not recorded until they are realized, the financial reporting may appear more conservative, thereby avoiding overstating profits.
How does realization convention relate to historical-cost accounting?
Both conventions emphasize recording transactions at their original cash value rather than current market value, reinforcing consistency and reliability in financial records.
Are there exceptions to the realization convention?
Yes, in some instances, accounting standards allow for revaluation model or fair value adjustments, but these are exceptions rather than the rule.
Related Terms
Historical-Cost Accounting: A method in which assets and liabilities are recorded at their original purchase price.
Gain: An increase in the value of an asset that is recognized upon sale or completion of a transaction.
Loss: A decrease in the value of an asset that is recognized upon sale or completion of a transaction.
Fair Value: The market value of an asset or liability, often used in contrast with historical cost.
Revaluation: The process of adjusting the book value of an asset to reflect its current market value.
Accrual Accounting: Recognizes revenues and expenses when they are incurred, regardless of when cash is exchanged.
Online Resources
- Investopedia: Realization Principle
- Accounting Coach: Realization Concept
- CPA Canada: Realization Convention in Financial Reporting
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial Accounting: An Integrated Approach” by Ken Trotman and Michael Gibbins
- “Accounting Theory and Practice” by Glautier, Underdown, and Morris
Accounting Basics: “Realization Convention” Fundamentals Quiz
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