Expense recognition definition
/What is Expense Recognition?
Expense recognition is the act of converting an asset into an expense. This is done when the utility of an asset has been consumed. Expense recognition can arise on a delayed basis, when expenditures are made for assets that are not immediately consumed. Examples of this type of expense recognition are:
When the period covered by a prepaid rent payment is complete.
When the advertising activities associated with a prepaid ad payment have been completed.
When the period covered by a prepaid general liability insurance policy is complete.
Expense recognition can also take place as soon as an expenditure is made. Such recognition may arise because the underlying utility of an acquired item was consumed within the same reporting period as the expenditure. This recognition may also arise because the cost of the acquired item falls below the capitalization limit of a business, so that the expenditure is always recorded as an expense as soon as it is incurred. Examples of this type of expense recognition are:
The purchase of office supplies
The incurrence of a liability associated with legal services already provided
The incurrence of a liability for utilities already consumed
The purchase of a laptop computer for which the cost is less than the corporate capitalization limit
The Matching Principle
Ideally, expense recognition should occur at the same time as the recognition of any revenue with which an expenditure is associated (the matching principle). For example, the expense recognition for the cost of goods sold associated with the sale of a product should be in the same period in which the sale was recognized. This concept only applies under the accrual basis of accounting. The matching principle does not apply under the cash basis of accounting, where expenses are recognized when the associated supplier invoice is paid.
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Examples of Expense Recognition
Here are five examples of expense recognition:
Depreciation expense. When a company purchases a fixed asset like machinery or equipment, the cost is initially recorded as an asset. Over time, as the asset is used, its cost is gradually expensed through depreciation. For example, if a $50,000 machine has a useful life of 5 years, the company might recognize $10,000 per year as a depreciation expense.
Amortization expense. Similar to depreciation, amortization applies to intangible assets such as patents, trademarks, or software. For instance, if a company buys a patent for $20,000 with a 10-year useful life, it would recognize $2,000 annually as amortization expense.
Prepaid expenses. When a company pays in advance for services like insurance or rent, the payment is recorded as a prepaid expense (an asset). As the service period passes, the prepaid amount is gradually expensed. For example, if $12,000 is paid for a one-year insurance policy, $1,000 would be recognized as an expense each month.
Cost of goods sold (COGS). When inventory is purchased, it is initially recorded as an asset. As the inventory is sold, its cost is recognized as an expense (COGS) on the income statement, aligning with the revenue earned. For example, if a company sells products worth $5,000 that originally cost $3,000, the $3,000 is recognized as COGS.
Accrued expenses. Sometimes, expenses are recognized before cash is paid. For example, if a company incurs $5,000 in utility expenses for December but pays the bill in January, it must record the $5,000 as an accrued expense in December to accurately reflect its liabilities and expenses for that period.
Presentation of Expense Recognition
When expense recognition occurs, the amount of the expense appears in the income statement, reducing the amount of profit that would otherwise be recorded. For a longer-term asset, this means that an asset is being eliminated from the balance sheet and moved to the income statement. For a shorter-term asset (such as office supplies) the asset is not present long enough to appear on the balance sheet - it is simply recorded at once in the income statement.
Fraudulent Expense Recognition
The timing of expense recognition is one of the more common forms of financial statement fraud, since the managers of a company may have an incentive to delay expense recognition in order to bolster the reported results of a reporting period. This situation most commonly arises when the compensation of managers is closely tied to the reported results of an organization.
How Expense Recognition Can Be Delayed
Expense recognition can be delayed under the cash basis of accounting, where recognition occurs when an invoice is paid, not when it is received.