Procedural Conventions - the Realization Convention

Procedural conventions - The realization convention

The realization convention is also closely related to the cost convention, for as the recorded value of an asset to the firm is determined by the transaction which was necessary to acquire it, so any change in its value may only be recognized at the moment the firm realizes or disposes of that asset. The realization convention reflects totally the historical origin of accounting as a method for recording the results of transactions. To an accountant there is no certainty of income until a sale has been made: hence, increases in value which have not been realized are not recorded.

The realization convention is strongly criticized by economists. They argue that if an asset has increased in value then it is irrelevant that it has not been sold. For economists, it is sufficient that the gain in value could be realized for that gain to be recognized. The realization convention, it is true, may lead to absurd conclusions.

Example

William James and George Lloyd have bought a pair of dilapidated cottages in Gwynedd for £5000. They spend £2000 on restoring the cottages, so that their total cost amounts to £7000. Both cottages are identical and form part of one unit, that is, they are semi-detached. The cottages were bought as part of a speculative venture to make profit out of the popularity of Welsh cottages as holiday homes. A businessman from Manchester offers to buy both cottages for £10,000 each, but the partners decide to sell only one of the cottages and to retain the other for sale at a higher price in the future.

From an accounting point of view, the cottage which is sold is recognized as being worth £10,000, and the difference of £6500 between the accounting cost and the sale price is the realized income. The second cottage, which could also have been sold for £10,000 to the same man, is recorded as being worth only £3500-being the costs associated with acquiring and restoring it.

Unrealized gains in value are widely recognized by non-accountants. Bankers, who are perhaps the most cautious of men, are prepared to lend money on unrealized values: businessmen reckon as income increases in the value of assets even though they are unsold-yet accountants will not do so unless and until a contract of sale has taken place which creates 4, legal right to receive the agreed value of the asset sold.

As a result of the realization convention, two classes of gains may be distinguished-'holding gains' which are increases in value resulting from holding an asset, and 'trading or operating gains' which are gains realized as a result of selling assets. 'Holding gains' are not recorded, but 'operating gains' are reported. The realization convention means, in effect, that the reported income of a business is a part only of the total increases in value which accrue to a firm during an accounting period.

The realization convention does not require the accountant to await the receipt of cash before recording a transaction. Indeed, in many cases the delivery of goods and the receipt of cash occur after the legal agreement which determines the timing of the transaction.

Example

On 1 January 19X0, Midlands Motor Engineers receive an order from one of their accredited dealers for five tractor engines each costing £400. The engines are despatched on 10 January, and on 5 February, a cheque for £2000 is received in payment.

From a legal point of view, the acceptance of the order on 1 January marks the timing of the sale, and the creation of the contractual obligation to deliver the engines as well as the contractual right to receive payment. Accounting follows the law in this respect, and it is common practice to write to confirm the receipt of an order and its acceptance, so as to leave no doubt as to the legal and accounting position.

On occasions, however, when a contract is for work which cannot be completed for a long period of time, the contract may stipulate when rights to payment arise. This is particularly the case as regards large civil engineering contracts, shipbuilding contracts and large government contracts. In these situations, accounting practices once more follow the law, and the timing of the right to receive cash is determined by the contract.

Example

Westlands Civil Engineering Co Ltd is awarded a Government contract for the building of a 50-mile section of a motorway. The work is required to be completed in three years. Payments are to be made by the Government on the basis of the work completed in each three-monthly period. It is agreed that an independent firm of quantity surveyors will certify the volume of work completed in each period, and that these certificates will form the basis for calculating the period payments to the company on the 'percentage of completion' method.

In accordance with this contract, the timing of the realizations will depend upon the issue of the certificates by the quantity surveyors.


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Read on: Procedural Conventions - the Cost Convention

Procedural conventions - The cost convention

By convention, however, accountants determine the value of an asset by reference to the cost of its acquisition, and not by reference to value of the returns which are expected to be realized. Hence, the 'value in use' of assets which the going-concern convention maintains is the cost of acquisition. To the accountant, the difference between the value in use and the cost of acquisition of an asset is income:

Value in use - Cost of acquisition = Income Example

W. E. Audent & Son is a professional firm of chartered accountants with... see: Procedural Conventions - the Cost Convention