The expense recognition principle represents the primary difference between accrual and cash accounting. As an essential reminder, the accrual accounting method recognizes revenues and expenses when they’re incurred, regardless of when cash is received or paid. In opposition, the cash accounting method recognizes revenue or costs at the moment cash is received or paid.
The expense recognition principle is used strictly under accrual accounting. It is commonly referred to as the matching principle as you don’t recognize and record a cost until those expenses are matched to the revenues they helped generate. When paired, the expense is recorded in the period the revenue was produced, not the period of the original cost.
What Would Expense Recognition Look Like?
Take, for example, a flower shop. The store spent $50,000 on new flower seeds. After two months, the newly bloomed flowers sold for $100,000. Since the original expense is directly related to the revenue produced from selling the flowers, the expense would be recognized and recorded on the financial statements in the period the flowers were sold.
In other words, the flower shop should match the $50,000 cost with the $100,000 revenue at the end of the generated revenues period.
What If There Is No Clear Connection?
So, what do you do with expenses that don’t have a clear cause-and-effect relationship? Some costs may be difficult to correlate with a given revenue. In a case like this, there are two classifications it could be categorized under.
Systematic and Rational Allocation
Costs that cannot be allocated to exact revenue may be assigned over the expense’s useful lifespan. Take, for example, equipment. It is hard to match a piece of equipment to a specific sales transaction, but we do know the machine will be functioning for approximately three years. Because of this, we would allocate the machine as a depreciation expense over those three years. This will allow any revenue resulting from the equipment to be spread throughout its entire useful lifespan while still matching and recording the initial cost.
Immediate allocation takes place when the future benefit of a cost cannot be determined. Most selling costs, administration costs, sales commission, and interest are all examples of what we would categorize as an immediate allocation. In this case, the expenses would be recognized and recorded immediately on the financial statements in the period that they are incurred.
Why Is the Expense Recognition Principle Important?
It is wise to use the expense recognition principle as it improves the overall quality of your financial statements. The proper recognition of expense and revenue gives a more accurate overview of results from operations and avoids possibly misstating profit or loss within a particular period.
Also, expense recognition lets investors get a better sense of the real economics of your business. By placing both revenues and expenses in the same period, your business’s financial statements will contain measures of both accomplishment and efforts. This transparency lets investors or other entities clearly assess your company’s performance.
Your ultimate guide to SMB accounting
Let’s get those books in order.