Realized income and recognized income are generally two confusing concepts since different companies use both these methods to report income. Whether a business realizes or recognizes its earnings as income depends on whether it uses the accrual method or the cash method of accounting. The key difference between realized income and recognized income is that while realized income is recorded once the cash is received, recognized income is recorded as and when the transaction is committed irrespective of whether cash is received then or at a future date.
CONTENTS
1. Overview and Key Difference
2. What is Realized Income
3. What is Recognized Income
4. Side by Side Comparison – Realized vs Recognized Income
5. Summary
What is Realized Income
Realized income is the income which is earned. Here, the income should be recognized after cash is received. This is also referred to as the ‘cash method’.
E.g. ABC Ltd has made a sale of $2,550 to EFG Ltd on credit. The credit period allowed to settle the transaction is 2 months. The receipt of funds will be recorded only after EFG pays in cash.
Accounting entry for the above is,
Cash A/C DR $2,550
Sales A/C CR $2,550
This is a less complicated approach compared to the accrual method of accounting for income. Due to its simplicity, many small businesses are enthusiastic in using this method to record income. Much less analysis is required under this method since cash received evidences the completion of the transaction. This method can also be advantageous from a tax perspective.
A company does not have to pay taxes on outstanding unpaid invoices until cash is received for them.
What is Recognized Income
Recognizing income occurs as soon as the business transaction is conducted irrespective of whether cash is received or not. This is in line with the accruals concept, thus referred to as the ‘accrual method’ of reporting income. Considering the above example, an account receivable for EFG Ltd. is recorded as soon as the sale is made. Accounting entry will be,
- When the sale is made,
EFG Ltd A/C DR $2,550
Sales A/C CR $2,550
- When cash is received at a later date,
Cash A/C DR $2,550
EFG Ltd A/C CR $2,550
Larger companies often opt for the accrual method to track and report income. In other words, a company doesn’t have to receive money to count it as income; it will recognize the amount in question as long as it has reason to believe it will be paid what it’s owed. As such, a company using the accrual method will have to pay tax on any recognized income it records, regardless of whether that income has been received at the time its taxes are due.
Accrual method provides a more reliable picture of the company’s financial situation since it captures all the transactions conducted within the accounting period. Most companies conduct a major portion of their sales on credit where the payment is received at a future date. This is especially true for retail organizations where they usually purchase goods on credit and settle manufacturers after the goods are sold. This can often take months, thus it is better for the manufacturer to record these sales on an accrual basis until cash is received.
Figure_1: Many retail organizations purchase goods on credit
What is the difference between Realized and Recognized Income?
Realized vs Recognized Income |
|
| Income is recorded once the cash is received. | Income is recorded once the business transaction is completed. |
| Method of recording transactions | |
| It uses cash method. | It uses accrual method. |
| Convenience | |
| This is more convenient compared to accrual method since this is less complex. | It is more complicated compared to the cash method; therefore, is not as convenient as realized income. |
| Accuracy | |
| This is less accurate since this method may not capture all the transactions conducted within the accounting period | This is more accurate since this method records all the transactions for a given accounting period. |
Summary – Realized vs Recognized Income
The key difference between realized and recognized gains is the involvement of cash receipt where a recognized gain becomes realized upon cash receipt. Financial statements of companies have to be prepared in accordance with accounting principles; thus, they should use the accrual method in order to allow better transparency.
Reference:
1.”Realized vs. Recognized Income.” The Finance Base. N.p., n.d. Web. 15 Feb. 2017.
2.”Realized Loss Vs. Recognized Loss.” Realized Loss Vs. Recognized Loss | Chron.com. N.p., n.d. Web. 15 Feb. 2017.
3.”What is the difference between the cash basis and the accrual basis of accounting? | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 15 Feb. 2017.
Image Courtesy:
1.”File:Pet Food Aisle”By I, Jeffrey O. Gustafson (CC BY-SA 3.0) via Commons Wikimedia