Why Expense Recognition Principle is Important to Small Businesses
Expense recognition is a key component of the matching principle; one of the 10 accounting principles included in Generally Accepted Accounting Principles (GAAP).
The expense recognition principle, following matching principles rules, states that expenses and revenues should be recognized in the same accounting period.
Overview: What is the expense recognition principle?
Similar to the revenue recognition principle, the expense recognition principle states that any expense that your business incurs should be recognized during the same period as the corresponding revenue.
Part of the matching principle, the expense recognition principle is only used in accrual accounting, since accrual accounting recognizes both revenue and expenses when they occur or when they are earned. This is different from cash accounting, which recognizes revenues and expenses when money changes hands.
How the expense recognition principle works
The expense recognition principle uses the same method as the revenue recognition principle. For example, Sara purchases 150 chairs in January. The cost of the chairs is $3,000, but Sara will not acknowledge the expense of purchasing the chairs until they are sold.
Here is the journal entry that Sara would make to record her initial purchase:
In the above journal entry, Sara would debit her inventory account, because she has added inventory in the amount of $3,000, while crediting her cash account, because she paid for the chairs immediately.
Notice that we have not yet expensed anything. If Sara did not record her inventory total properly, the amount of inventory stated on her balance sheet would be inaccurate.
In February, Sara sells all 150 chairs for $6,000. In order to follow the expense recognition principle as well as the matching principle, Sara will need to record the expense related to purchasing the chairs as well as the revenue earned in February from selling the chairs.
This will ensure that both income and expenses are recorded in the same month.
|2-28-2020||Cost of Goods Sold||$3,000|
Looking at the journal entry above, you can see that Sara recorded her total payment of $6,000 in her cash account as a debit, since her cash account was increased when the money was received.
The cost of goods sold account was also debited, which indicates the expense incurred when purchasing the inventory in January.
Revenue is increased, or credited, since $6,000 was received from the purchase of the chairs, and finally, the inventory account was decreased by the amount of inventory sold, which was all 150 chairs. If revenue was not recorded properly, Sara’s income statement for the month of February would have been inaccurate.
Using the example above, let’s say that Tim, Sara’s salesperson, receives a 10% commission on sales. Since Tim sold all of the chairs for a total of $6,000, he is owed a commission of $600 (10%) on the sales.
Even though Tim will not receive his commission until March, the expense should still be tied back to the sales revenue received in February. In order to properly account for the commission in the correct month (February), Sara will need to accrue the commission expense:
By recording the above journal entry, Sara has recorded the commission expense in the correct month, even though it won’t be paid until March. When it is paid, Sara needs to remember to reverse the accrual entry, or her commission expense will be overstated.
What are the methods to recognize expenses?
While the majority of business expenses fall under the cause-and-effect method, which easily matches revenues and expenses like the example above, there are other methods used to classify expenses that occur that cannot be tied to a particular revenue.
Here are the three main methods that are used to recognize expenses properly:
Method #1: Cause and effect
The journal entries above illustrate the cause-and-effect method of expense recognition. For instance, the expense of the chairs purchased in January are clearly linked to the revenue earned in February when those same chairs were sold.
In any sales transaction, cost of goods sold is directly related to the revenue earned by selling goods to customers. Any commission earned by a salesperson would also fall under the cause and effect method, since the commissions earned are directly tied to the chair sales.
Method #2: Systematic and rational allocation
It can be difficult to assign an expense to a particular revenue source, especially when purchasing items such as factory equipment. However, when equipment is purchased, you will expense the usage of the equipment over its useful life through depreciation.
For example, In February, Sam purchased a $10,000 machine for his factory. While he cannot tie the expense to a specific revenue source, the machine will be helping to produce revenue throughout its useful life, which is estimated at seven years.
In order to properly account for that expense, Sam will need to depreciate the cost of the equipment for the next seven years.
|2-28-2020||Fixed Assets -- Machinery||$10,000|
This first journal entry above shows how to record the initial expense.
|2-28-2020||Depreciation Expense -- Machinery||$119.05|
The next journal entry above shows you how to expense the machinery purchased over its useful life, which is seven years. This journal entry would be recorded each month while the machinery is still being used until the end of its useful life, or until the machinery is retired or sold.
By recording depreciation monthly, you will be able to tie the expense of the machinery to the revenue earned by the use of the machinery.
Method #3: Immediate recognition
Immediate recognition is perhaps the easiest method of expense allocation, since it’s done on a regular basis. Immediate recognition is used for all of your period costs, which include general operating expenses, administrative expenses, utility costs, selling costs, sales commissions and any other incurred expenses.
These expenses are typically recognized immediately, since in most cases it’s difficult, if not impossible, to tie any future revenue or other benefits directly to these expenses. These period costs are immediately recognized rather than recognized at a future date.
Expense recognition is a key component of accrual accounting
If you use accrual basis accounting, you should also be using the expense recognition principle. Part of the matching principle, the expense recognition principle states that expenses should be recognized in the same period as the related revenue.
If expenses are recognized when they are paid, you are using cash basis accounting. Recognizing both revenue and expenses properly ensures that your financial statements will accurately reflect your business.
If you’re still tracking revenue and expenses manually or by using spreadsheets, we recommend that you check out The Ascent’s accounting software reviews to automate the process and make your life a lot easier.
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