Expense recognition principle
/What is the Expense Recognition Principle?
The expense recognition principle states that expenses should be recognized in the same period as the revenues to which they relate. If this were not the case, expenses would likely be recognized as incurred, which might predate or follow the period in which the related amount of revenue is recognized. This concept only applies to the accrual basis of accounting. Under the cash basis of accounting, expenses are recognized when they are paid for, which may not be in the same period as the related revenue.
Some expenses are difficult to correlate with revenue, such as administrative salaries, rent, and utilities. These expenses are designated as period costs, and are charged to expense in the period with which they are associated. This usually means that they are charged to expense as incurred.
Impact of the Expense Recognition Principle on Income Taxes
The expense recognition principle has an impact on the timing of income taxes, since it impacts the recognition of profits. For example, if you were using the accrual basis of accounting, profits would be recognized in conjunction with the related revenues, resulting in a reasonable amount of taxable income in each reporting period. However, if you were using the cash basis of accounting, then profits might be too high in one period (because expenses had not yet been paid for, and therefore not recognized), while profits might be too low in the next period (when the expenses were paid for, and therefore recognized). The result is a high degree of variability in the amount of income taxes owed from one reporting period to the next.
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When to Use the Expense Recognition Principle
The expense recognition principle is a core element of the accrual basis of accounting, which holds that revenues are recognized when earned and expenses when consumed. If a business were to instead recognize expenses when it pays suppliers, this is known as the cash basis of accounting.
If a company wants to have its financial statements audited, it must use the expense recognition principle when recording business transactions. Otherwise, the auditors will refuse to render an opinion on the financial statements.
Examples of the Expense Recognition Principle
Here are several examples of how the expense recognition principle would be used for a business:
Cost of goods sold. When a retailer sells products, the cost of those goods is recognized as an expense in the same period as the sales revenue. For instance, if a business sells $5,000 worth of inventory in March, the cost paid to purchase or produce that inventory must also be recorded as an expense in March.
Sales commissions. Commissions paid to sales staff are recorded as expenses in the same period when the related sales revenue is recognized. If a salesperson earns a commission for a sale made in April, the expense must also be recorded in April, even if the commission is paid in May.
Depreciation expense. For fixed assets like equipment or buildings, depreciation spreads the cost over the useful life of the asset. The expense is recognized periodically (typically monthly or annually) to match the revenue the asset helps generate during each period.
Wages and salaries. Employee wages are recognized as expenses in the period when employees perform the work, regardless of when they are paid. For example, if employees work the last week of December but are paid in January, the wages expense should be recorded in December.
Advertising costs. If a company runs an advertising campaign in March to boost sales that month, the advertising expense should be recognized in March. This matches the cost of the campaign with the revenue generated from increased sales during the same period.