Expense Recognition PrincipleDefined along with Examples
The matching principle is an essential part of accrual accounting.
In fact, it is one of the Generally Accepted Accounting Principles.
The expense recognition principle is an important part of the matching principle and dictates that expenses need to be recognized in the same period as their corresponding revenue.
Explaining the Expense Recognition Principle
The expense recognition principle is a fundamental principle of accounting.
It states that any expenses need to be recognized in the same accounting period as their related revenue.
The expense recognition principle is used in accrual counting but not in cash accounting because accrual accounting recognizes expenses as well as revenue at the time they occur or are earned.
Whereas cash accounting only recognizes a business’s expenses and revenues when the expense is paid or the business receives the revenue.
Expense Recognition Principle Example
The revenue recognition principle and the expense recognition principle both used the same method.
As an example, suppose Becky buys 1,000 T-shirts for $2 each, but she does not recognize the expense until she sells the T-shirts.
Becky would record the following entry for her purchase.
For her journal entry, Becky debits the inventory account for $2,000 and credits the cash account because she used cash to pay for the T-shirts when she bought them.
At this point, Becky did not expense anything.
Had Becky not recorded the inventory she purchased, then the inventory amount recorded on her balance sheet would not be correct.
Becky sold the 1,000 T-shirts in June that she had purchased in April for $5,000.
Becky then recorded the expense she incurred by buying the T-shirts in addition to the revenue she earned in June when she sold the T-shirts.
By doing this, Becky was following the expense recognition principle and the matching principle.
This meant that Becky recorded her income and expenses in the same accounting period.
|Cost of Goods Sold||$2,000|
This journal entry shows that Becky recorded a payment of $5,000 by debiting the cash account because this account increased by $5,000.
She also credited the account cost of goods sold to show the expense that she incurred back in April when she bought the T-shirts.
Becky also debits the revenue account since she received $5,000 by selling the T-shirts.
Additionally, she credits the inventory account because this account decreased when the T-shirts were sold.
Had Becky not recorded the revenues she received, her income statement for June would not have been accurate.
If Becky had employed Jane, a sales clerk, to sell the T-shirts and paid this sales clerk by giving her a 15% commission for any sales, Becky would have had to pay a commission of $750.
Jane would be paid her commission in July.
However, this expense would be associated with the revenue Becky received in June.
Therefore, the commission would be accounted for in June, meaning Becky would need to accrue the amount of the commission expense.
Becky records this journal entry in June to record the commission expense.
This is the correct month to record the expense in even though she pays the commission to Jane in July.
In July, when Becky pays the commission expense, she will need to reverse the accrual entries she made.
Otherwise, she will overstate the commission expense.
The Methods for Recognizing Expenses
Most business expenses will be recognized using the cause and effect method.
This method makes it easy to match expenses and revenues, as shown in the previous example.
However, there are several methods that a business can use if they are trying to classify an expense that they can’t easily associate with any specific revenue.
Here are three different methods that businesses can use to recognize expenses:
Cause and Effect
The journal entries recorded earlier in this article show a method of expense recognition called cause-and-effect.
To show how this method works, it is clear that the T-shirts purchased in April were the ones sold in June.
This means that the expense of these T-shirts is related to the revenue of the shirts sold in June.
For all sales transactions, the cost of goods sold will be directly related to any revenue that is earned by selling a product to a customer.
This applies to the sales commission earned by the salesperson as well.
The commission will be included in the cause and effect method because any commission the salesperson earns is directly connected to the sale of the T-shirts.
Systematic and Rational Allocation
Sometimes the problem with assigning expenses is that it can be hard to identify the exact source of revenue they match.
This is particularly true for businesses that purchase assets such as machinery for a factory.
But, when a business purchases this type of equipment, it will be expensed through depreciation over its useful life.
As an example, suppose Sally buys a machine for her toy factory that costs $20,000.
She can’t connect this expense to any certain source of revenue.
However, the machine will be contributing to the revenue the factory produces during its useful life.
The useful life of the machine is expected to be five years.
Sally will need to account for this expense properly.
To do this, Sally will depreciate the cost of the machine over the following five years.
The following entry will show how Sally recorded the initial expense of purchasing the machine.
The entry below will show how Sally expenses the machine she purchased over the five-year useful life of the machine.
Sally will record this journal entry every month during the time the machine is being used throughout its useful life or until she sells or retires the machine.
|06-30-2021||Depreciation Expense — Machinery||$333.33|
When depreciation is recorded monthly, it allows a business to connect the expense of its machinery to the revenue it earns through using the machinery.
One of the easiest methods for allocating expenses is immediate recognition.
This is due to the fact that the expenses are recognized regularly.
Businesses use immediate recognition for any of their period costs, such as administrative expenses, sales commissions, general operating expenses, utility costs, as well as other incurred expenses.
These expenses are generally recognized immediately because it is hard to connect these expenses to any future revenue or benefits.
Expense Recognition is an Important Part of Accrual Accounting
For businesses that use accrual accounting, it is essential to follow the expense recognition principle.
The expense recognition principle, a component of the matching principle, dictates that expenses be recognized in the same accounting period as the revenue it is associated with.
Companies that recognize expenses at the time they pay them are using a method of accounting called cash basis accounting.
Businesses that follow the matching principle will have financial statements that more accurately represent their business’s financial position.
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