Expense recognition principle

Definition and explanation

The expense recognition principle is one of the most basic and salient parts of GAAPs, which lays down guidelines and rules regarding the recognition of expenses in the accounting books of business entities. All businesses incur various expenses over time. Right from the incorporation stage to the operational phase, the expansion phase, and even at the time of winding up, expenses are incurred every step of the way. Expenses have a bearing on both the profitability and financial condition of the business entities. Thus, their appropriate recording in the books of accounts assumes utmost importance.

The expense recognition principle states that an expense should be recognized in accounts when it is incurred, irrespective of the timing of its cash payment. When does a business incur an expense? An expense is considered to have been incurred during the period in which the business actually benefits from that expense. Since this principle is core to the accrual method, it can’t be ignored while recording transactions under modern double-entry accounting.

All expenses need to be accounted for correctly, as they not only impact the profit and loss account (or income statement) but also a number of balance sheet items. For instance, if the cash payment for an expense is made in advance of its actual incurrence, it must be recorded as an asset to be expensed out in the future. On the other hand, if an expense has actually been incurred but not yet paid, an expense as well as a liability for the same are recorded in the books. If an entity fails to follow the expense recognition principle properly, its financial statements will exhibit misleading numbers and lose their acceptability with key stakeholders.

The two key terms in this discussion are “incurrence of expense” and “payment of expense.” The incurrence and payment of an expense may both occur at the same time or at different times. The expense recognition principle focuses our attention on the incurrence of booking an expense, not its payment.

Examples of expense recognition principle

The expenses that a business needs to record as per the expense recognition principle mostly fall into the following three categories:

(1). Expenses that have a direct relationship with revenue

Expenses that can be directly traced to related revenue fall under this category, for example, inventory expenses. Suppose Atlanta Inc, is a trading company operating in Michigan. It has imported 10,000 units of kitchen appliances from Pakistan at $100 per unit. During the current year, it has managed to sell only 6,000 units of those appliances at $125 each.

As per the expense recognition principle, the entire purchase cost of $1,000,000 would not be expensed out in the current period. Instead, only the cost of units sold ($600,000 = $100 x 6,000 units) will be treated as the inventory expense and charged to the cost of goods sold account. The cost of unsold units ($400,000 = $100 x 4,000 units) would be recognized as an asset on the year-end balance sheet and will be expensed out as and when they are sold in the forthcoming period(s).

(2). Expenses that do not have an established and direct relation with revenue

Expenses that cannot be tied one-to-one with revenue earned fall under this category. For example, the purchase of fixed assets. Suppose, to lower its annual transportation cost, Atlanta Inc. has purchased five delivery trucks – two for transporting products to its warehouses situated in different localities and three for delivering products to merchants and customers in various cities. The usage of the trucks cannot be directly linked to sales. Thus, the depreciation cost of all five trucks would be expensed on a reasonable basis, apportioned over their useful economic lives.

(3). Time related expenses or period costs

Commercial entities incur numerous expenses that cannot be directly matched against revenues on a per-product or per-unit basis. They are, however, essential for the normal continuity of business operations. Such expenses are known as period expenses or period costs. Examples include rental expenses, staff salaries, utility expenses, etc. Such expenses are often charged on a periodic basis for the period within which they benefit and support the firm. To learn more about these expenses, read our article product costs and period costs from “classifications of cost” chapter.

Why is the expense recognition principle important?

A couple of reasons why the expense recognition principle is important to follow are given below:

Correctness of accounting records

Since expenses have a direct and straightforward impact on profitability, their correct recognition in accounting books is very important. The expense recognition principle ensures an appropriate and acceptable recording of each and every business transaction triggered by various expenses and ensures that journal books, ledger accounts, and finally financial statements exhibit a true and fair view of a firm’s financial affairs.

Amenable to audit and meets international standards

Finally, adherence to the expense recognition principle under accrual accounting is mandatory to get the books of accounts audited in a smooth way. Books that don’t adhere to this principle will not have global recognition, nor will they be accepted by key stakeholders of the entity, such as investors, bankers, financiers, government institutions, etc.