What is the expense recognition principle?
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The expense recognition principle is a small but critical part of U.S. generally accepted accounting principles (GAAP). 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?
The expense recognition principle states that you must acknowledge your expenses and the revenue from those expenses in the same accounting period. An example of the expense recognition principle is that 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.
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 the way companies track and document profits, maintain financial statement accuracy, and avoid tax penalties.
The expense recognition principle is a part of the matching principle, a pillar of U.S. 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. U.S. GAAP states that businesses must recognize revenues on their income statement in the period they were realized and earned.
Businesses must have a reasonable degree of certainty that 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.
These principles smooth income reporting, giving you a good idea of what drives revenues and the expenses your business needs to function smoothly.
How does the expense recognition principle work?
The expense recognition principle works in tandem with the revenue recognition principle. Here's how both work together in practice. Let's say your company purchased $40,000 worth of raw materials in May. 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 goods created from the raw materials.
You sell finished goods in July and earn revenues of $100,000. At this point, you must recognize the expenses you incurred selling the goods along with the revenue.
In this example, the only expense incurred involved purchasing 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:
- Financial statement accuracy: Recognize expenses in the wrong periods, and 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 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 the financial performance of that period.
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.
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.
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 tough. For instance, 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 lifetime might last for several years. Recognizing the expense over and over is illogical.
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. Here's what your journal entries will look like, assuming a $50,000 machine cost and a 10% depreciation rate:
Method 3: Cause and effect
Cause and effect is the most prevalent expense recognition method. In this method, you’ll record expenses in the same period as the revenue generated by those costs. 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 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.
Your journal entries will look like this:
Once you've sold the finished goods:
Simplify expense reporting with Ramp
Ramp makes expense reporting simple by centralizing all of your data in one place. Here's how our platform helps you manage expenses:
- Real-time expense reporting and receipt collection. Expenses incurred when using Ramp's 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.
Learn more about how Ramp can streamline your expense management.