Expenses are recognized in the same period as the related revenue

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Expense recognition will typically follow one of three approaches, depending on the nature of the cost:

• Associating cause and effect: Many costs are linked to the revenue they help produce. For example, a sales commission owed to an employee is based on the amount of a sale. Therefore, commission expense should be recorded in the same accounting period as the sale. Likewise, the cost of inventory delivered to a customer should be expensed when the sale is recognized. This is what is meant by associating cause and effect, and is also referred to as the matching principle.
• Systematic and rational allocation: In the absence of a clear link between a cost and revenue item, other expense recognition schemes must be employed. Some costs benefit many periods. Stated differently, these costs expire over time. For example, a truck may last many years; determining how much cost is attributable to a particular year is difficult. In such cases, accountants may use a systematic and rational allocation scheme to spread a portion of the total cost to each period of use (in the case of a truck, through a process known as depreciation).
• Immediate recognition: Last, some costs cannot be linked to any production of revenue, and do not benefit future periods either. These costs are recognized immediately. An example would be severance pay to a fired employee, which would be expensed when the employee is terminated.

Payment vs. Recognition

It is important to note that receiving or making payments are not criteria for initial revenue or expense recognition. Revenues are recognized at the point of sale, whether that sale is for cash or a receivable. Expenses are based on one of the approaches just described, no matter when payment occurs. Recall the earlier definitions of revenue and expense, noting that they contemplate something more than simply reflecting cash receipts and payments. Much business activity is conducted on credit, and severe misrepresentations of income could result if the focus was simply on cash flow.

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Expense Recognition Principle Definition

Expenses recognition primarily refers to the accounting principle that follows the accrual basis concept, where expenses are recognized and matched in the books in the same period as revenues.

Types of Expense Recognition Principle

There are two types of expense recognition principles –

• Accrual Basis – Under this accrual principleAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more expense will be recognized in the books as and when it is matched with the revenue.  For example, telephone bills per month are $500 paid for 13 months. Under this method, $6000 for 12 months will consider this year’s rest of $500 for one month next year.
• Cash Basis – Under this cash basis method, the expense will be recognized in the books when it is paid or received. Consider the above example; under this method, a full $6500 will be recognized in the same year when it is paid.

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Examples of Expense Recognition Principle

Let’s understand this concept with the help of the following example.

Example #1

Company X paid $ 50000 to the supplier for material, which he will sell next month for $ 80000. In this case, X will recognize $ 50000 as expenses in the next month to match with revenue; otherwise, the current month’s expenses will be high, and the tax amount will be high in the next month. It is also done for income tax. Without this principle, income tax in the current month will be less than next month.

Example #2

In some cases, matching revenue concept is not possible; therefore, expenses recognized in the period for which they are related, for example, salary, rent, electricity, administrative expensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more.

Suppose company X paid 13-month rent amounting to $ 13000, and per month rent is $ 1000.

Journal entry in 1 year-

In the below scenario, X will recognize $12000  as rent for this year, and the balance of $1000 will recognize the expense in the next year, and It will show rent under advances.

Journal Entry Next Year

This year’s rent expense adjusted with advance rent.

Advantages of Expense Recognition Principles

• During the Audit of financial statement, if the Auditor finds books of the company’s accounts have not followed the accrual concept, then the Auditor may qualify the Audit report. For example, as per the standard on Audit, the Auditor has to check whether the company is following the accrual concept or not. If he fails to identify, then there will be professional misconduct by the Auditor, so the Audit has to check the same. Therefore, a company following the accrual concept can save itself.
• The accrual concept depicts the true profitability of an organizationProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more.
• The accrual concept shows a more accurate financial statement than cash because cash basis recognizes when it is paid or received that may consist of the amount relating to another period also.

Suppose company X paid $ 26000 for electricity for 13 months and per month electricity is $ 2000.

As per the accrual basis, electricity expense will be $ 24000, i.e., $2000 per month, and it will recognize $ 2000 in the next year as it is related to next year’s expense, but as per cash basis full $ 26000 will be recognized in the books in the same year.

As we can see, the cash basis considers $ 2000 also, which is about next year; hence, it causes less profit this year and more profit in the next year.

Those following accrual concepts need not report anything in notes to accounts, but if the company is following a cash basis, it has to report in notes to accounts.

• Stakeholders are more focused on the accrual concept rather than the cash basis because the accrual concept shows the permanence of business and reflects the accurate and fair view ofFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more financial statementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.
• An accrual basis is beneficial in the preparation of projected financial statements. It can determine the upcoming expense and sales, which provides a great tool in Tax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities.read moretax planningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities.read more.
• Cash basis method is simple to use because it records the transaction when it is paid, it is generally used by small companies and individuals.

Disadvantages of Expense Recognition Principles

• It is challenging for a small company to manage its books accounts because the accrual concept requires monthly reporting and a skilled employee to manage it properly.
• The major disadvantage of maintaining books of accounts on accrual is that we will report revenue and expenses as and when they happened without waiting for actual cash received; hence, it is sometimes difficult to pay taxes without cash received in hand.
• It is difficult for a small company where there is a liquidity problem. It has to pay taxes without having actual cash received.
• It is difficult to change from one method to the accrual method because it requires a cost.
• The cash basis recorded the transaction when it was paid. Still, in reality, there can be some expenses that need to be paid in the future, so investors will not be able to decide whether the company is making a profit or loss.

 Limitations

• The accrual basis principle does not suit a small company with a liquidity problem that exists, and it is also difficult for a small company at the time of payment of tax.
• The cash Basis principle does not depict the true profitability of a company.
• Accrual basis sometimes becomes very complicated, requiring skilled employees to maintain the same.

Change in Expenses Recognition Principles

A change in expense recognition principles is a change in accounting policy, and disclosure is required in the notes to the accounts.

Recommended Articles

This has been a guide to the Expense Recognition Principle and its definition. Here we discuss types of expense recognition principles and examples, advantages, disadvantages, and limitations. You can learn more about it from the following articles –

• Expense Accounting
• Journal Entries for Expenses
• Prepaid Expenses Journal Entry
• Selling Expenses