What is the expense recognition principle?

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

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

What is the expense recognition principle, and how does it work?

The expense recognition principle is a fundamental concept in accrual accounting. It stipulates that an expense should be recorded in the same period as the revenue it helped generate. Another name for the expense recognition principle is the matching principle.

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

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. The goal of the matching principle is to standardize how companies track and document profits, maintain financial statement accuracy, and avoid tax penalties.

Accrual accounting vs. cash accounting

Whether you follow the expense recognition principle depends on the accounting method your business uses—specifically, whether you use accrual accounting or cash accounting:

• In accrual basis accounting, you record expenses as soon as you incur them, regardless of whether you’ve paid for them. These are known as accrued expenses. Similarly, you report revenues as soon as you’ve delivered goods or services with the expectation that payment will follow.
• In cash basis accounting, you only record expenses when you pay them out, regardless of when you purchased the goods or services. The same goes for your revenues: You report them on your income statement only after you’ve received payment from your client or customer.

The expense recognition principle essentially forms the foundation of the accrual basis of accounting. It helps to provide a more realistic and accurate picture of your company’s current liabilities and overall financial performance at any given time.

How does the expense recognition principle relate to revenue recognition?

Alongside the expense recognition principle, revenue recognition is one of the core pillars of the accrual method of accounting. Under US GAAP, businesses must record revenues on their income statement in the period they were realized and earned.

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.

Together, these accounting standards help smooth income reporting, giving you a clearer picture of what drives revenue and the expenses your business must incur to function properly.

What’s an example of the expense recognition principle?

As explained above, the expense recognition principle works in tandem with the revenue recognition principle. Here's an example of how both work together in practice.

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

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

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

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. An effective expense management process will help you identify and record all 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:

• Maintains accurate financial statements: If you recognize expenses in the wrong period, you'll misstate your net income and cash flow, disrupting your spend management processes
• Tax implications: Misstating revenues and income opens the door to unnecessary tax burdens or penalties. Moreover, regulators and investors take a dim view of repeated changes to audited financial statements.
• Creates financial transparency: When you match 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. Here are the three methods you can use to recognize expenses:

Method 1: Immediate recognition

Immediate recognition is the most straightforward 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.

You incur these expenses in a relatively predictable manner. More importantly, tying these fixed costs to different sets of revenue is essentially impossible. For example, what percentage of your office rent expenses went towards generating your revenue? Immediate recognition works best in vague or unclear scenarios like this.

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

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 useful life might last for several years. Recognizing the expense over and over is illogical.

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

‍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.

Here's an example. You incur $30,000 in cost of goods sold (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 accounting period.

Your journal entries would initially look like this:

And once you've sold the finished goods:

Simplify financial reporting with Ramp

Ramp simplifies expense management and financial reporting by centralizing all your data in one place. Here's how:

• Real-time expense reporting and receipt collection: Expenses incurred when using Ramp's business expense cards appear on your dashboard in real time
• Digitize expense policies: Create merchant-specific controls and spending limits to streamline employee spending
• Set multi-level approval workflows: Create a clear audit trail with multi-layered approvals that automatically pull in the right stakeholders for every expense
• Integrates with popular accounting platforms: Ramp integrates with the financial tools you already have in your tech stack, including accounting software like Xero, Sage Intacct, QuickBooks, and NetSuite

Ready to learn more about how Ramp can streamline your financial reporting processes? Check out our interactive demo environment and see why companies that choose Ramp save an average of 5% a year across all spending.