What is the expense recognition principle?

What is the expense recognition principle?

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The expense recognition principle is a small but critical part of US Generally Accepted Accounting Principles (GAAP). Incorrect expense recognition can skew income statements and balance sheet numbers, leading to restated financial results.

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In this guide, we’ll review the expense recognition principle and the three methods you can use to recognize expenses.

How the expense recognition principle works

As a basic example of the expense recognition principle, if your company purchases t-shirts for $2,000 and sells them for $4,000, you must recognize the revenue ($4,000) and the expense ($2,000) in the same period.

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In this case, the expense leads to revenue generation. If you didn't incur expenses purchasing t-shirts, you couldn't have sold them for a profit. This is done to standardize how companies track and document profits, maintain financial statement accuracy, and avoid tax penalties.

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The expense recognition principle is a part of the matching principle, a pillar of US GAAP. Businesses that follow accrual accounting use the matching principle. If you use cash accounting, the expense recognition principle doesn't apply to you since you’ll record expenses and revenues when cash enters or leaves your accounts.

How does the expense recognition principle relate to revenue recognition?

Revenue recognition is a pillar of accrual-based accounting with the expense recognition principle. The United States GAAP states that businesses must recognize revenues on their income statement in the period they were realized and earned.

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Businesses must be reasonably certain they’ll receive revenues upon completing an activity. When paired with the expense recognition principle, revenue recognition helps your business present a transparent and accurate financial picture.

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These principles smooth income reporting, giving you a good idea of what drives revenue and the expenses your business needs to incur to function properly.

What’s an example of the expense recognition principle in accounting?

The expense recognition principle works in tandem with the revenue recognition principle. Here's how both work together in practice.

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Let's say your company purchased $40,000 of raw materials in March. Your journal entries would look like this:

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Note that you haven't recorded an expense yet. This is because you haven't earned any revenues from selling goods created from the raw materials.

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You sell finished goods in May and earn revenues of $100,000. At this point, you must recognize the expenses you incurred selling the goods along with the revenue:

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In this example, the only expense incurred was the purchase of raw materials. In reality, you'll have other expenses to account for, such as operating expenses. Make sure you're on top of your expense management processes to record these numbers accurately.

Why is the expense recognition principle important?

The expense recognition principle is central to determining your business's financial health. Here are a few reasons why this principle is important:

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• Financial statement accuracy: If you recognize expenses in the wrong periods, you'll misstate net income and cash flow, disrupting your spend management processes.
• Tax implications: Misstating revenues and income creates tax burdens or penalties. Regulators and investors take a dim view of repeated changes to audited financial statements.
• Determines your business accounting approach: The expense recognition principle is central to accrual accounting. This approach is very different from cash accounting and reflects your perspective when stating financial results.
• Creates financial transparency: By matching expenses with revenues, you can better understand how you generate the latter.

The 3 expense recognition methods

Recognizing an expense means recording it during the period it’s incurred or when it helps to generate revenue to accurately reflect that period’s financial performance.

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Here are the three methods you can use to recognize expenses:

Method 1: Immediate recognition

Immediate recognition is the most intuitive way of recording an expense. In this method, you recognize an expense when you incur it. For instance, you can immediately recognize fixed periodic expenses such as rent payments, utility bill payments, and selling costs.

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You incur these expenses in a relatively predictable manner. In addition, tying these fixed costs to different sets of revenue is impossible. For example, what percentage of office rent went towards generating your revenue? Due to the nature of these situations, immediate recognition works best.

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Note that you must recognize these expenses immediately, not at a future date. You will automatically associate them with the revenues you generate during a period.

Method 2: Systematic and rational allocation

Some expenses clearly contribute to revenues, but recognizing them is difficult. Imagine you purchase a new machine that creates more manufactured units and sales. The machine's purchase cost leads to the revenues you earn.

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However, should you recognize the machine's total cost every time it produces a saleable unit? This method makes no sense since the machine's lifetime might last for several years. Recognizing the expense over and over is illogical.

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In such instances, the systematic and rational allocation method comes to the rescue. You can depreciate the machinery and tie that expense to revenues earned. Assuming a $50,000 machine cost and a 10% depreciation rate, here's what your journal entries would look like:

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Method 3: Cause and effect

Cause and effect is the most common expense recognition method. In this method, you’ll record expenses in the same period as the revenue they generate. Naturally, you must establish a clear link between expenses and revenues for this method to work.

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Here's an example. You incur $30,000 in COGS and sell the finished product the following month, earning revenues of $100,000. Additionally, you incur a salesperson's commission expense of $10,000. Both expenses and the revenue they're tied to must be recorded in the same period.

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Your journal entries would look like this:

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Once you've sold the finished goods:

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Simplify expense reporting with Ramp

Ramp makes expense reporting simple by centralizing all your data in one place. Here's how our platform helps you manage expenses:

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• Real-time expense reporting and receipt collection: Expenses incurred when using Ramp's business expense cards appear on your dashboards in real-time.
• Digitize expense policies: Create merchant-specific controls and spending limits to streamline employee spending.
• Set multi-layer approval to create audit trails: Create multi-layered workflows that automatically involve the right stakeholders connected to every expense.
• Integrates with popular accounting platforms: Ramp pairs with popular accounting platforms like Xero, Sage Intacct, QuickBooks, and NetSuite.

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Learn more about how Ramp's expense management software can streamline your processes.