Definition and explanation
Expense recognition principle is one of the basic and salient parts of GAAP which lays down the guidelines and rules regarding the recognition of expenses in accounting books of business entities. All businesses incur various expenses over time. Right from the incorporation stage to operational phase, expansion phase and even at the time of winding up, expenses are incurred on every step of the way. Expenses have a bearing on both profitability and financial condition of the business entities. Thus, their appropriate recording in the books of accounts assumes utmost importance.
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 in the period in which the business actually gets benefit 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 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 is recorded in the books. If an entity fails to follow the expense recognition principle properly, its financial statements would exhibit misleading numbers and lose their acceptability to key stakeholders.
The two key terms in this discussion are “incurrence of expense” and “payment of expense”. The incurrence and payment of an expense both may occur at the same time or at different times. The expense recognition principle focuses our attention on the incurrence for booking an expense, and not its payment.
Examples of expense recognition principle
The expenses in a business that we need to record as per expense recognition principle majorly fall under the following three categories:
(1). Expenses that have a direct relationship with revenue
Expenses which 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 @ $100 per unit. During the current year, it has managed to sell only 6,000 units of those appliances @ $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 inventory expense and charged to cost of goods sold account. The cost of unsold units ($400,000 = $100 x 4,000 units) would be recognized as an asset in year end balance sheet and will be expensed out as and when they are sold in 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, purchase of fixed assets. Suppose, to lower its annual transportation cost, Atlanta Inc. has purchased 5 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 the sales. Thus, the depreciation cost of all five trucks would be expensed on a reasonable basis, apportioned over their useful economic life.
(3). Time related expenses or period costs
Commercial entities incur numerous expenses which cannot be directly matched against revenues on per product or per unit basis. They are, however, essential for normal continuity of business operations. Such expenses are known as period expenses or period costs. Examples include rental expenses, staff salaries, and utility expenses etc. Such expenses are often charged on a periodic basis to 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 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 firm’s financial affairs.
Amenable to audit and meets international standards
Finally, adherence to 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, financers and government institutions etc.