Business owners need to spend money where they will get results, but how can you tell which expenses are generating a return on investment (ROI)? The expense recognition principle is an accounting tool in the business owner’s toolbox to identify expenses and any associated revenue related to those expenses. This information can help business owners better plan their investments to maximize their ROI and cut expenses that aren’t leading to performance.
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The expense recognition principle is a concept that outlines when a business’s expenses are recognized in the company’s financials. Typically, the expense recognition principle involves expenses being recognized and recorded in the same period as the revenues associated with those expenses (under accrual accounting).
This method of accounting is a way for businesses to match expenses with the revenues related to those specific expenses (for example, commissions owed to employees for certain sales recorded when those sales happen, rather than later). Put another way, it shows the business using assets and converting them to expenses as their utility is expended.
The question of when expenses should be recognized represents the biggest difference between cash and accrual accounting. Instead of recognizing revenue and expenses in the same period, if a business instead recognizes expenses when they’re incurred, that means it’s using cash accounting.
Accrual accounting centers on the idea that expenses should be recognized during the same period as the revenue that the expenses are related to. When a company undertakes expenses to engage in some revenue-producing activity, the expense recognition principle says that those expenses should be reflected in the same period as the revenue derived from those expenses.
The expense recognition principle is a principle of accounting that helps businesses decide when and how to recognize expenses that they incur. Under the expense recognition principle, if work has been performed and you haven’t paid for it yet, you book it as an expense and accrue it as a liability. Conversely, if you have paid for something but haven’t received the associated benefit (revenue), you would book that benefit as an asset (a prepaid expense).
The bottom line is to match your business’s revenue and expenses in the same period.
On the other hand, businesses may choose to use the cash basis of accounting, wherein they recognize revenue or expenses when cash changes hands (whether going in or out) rather than when a transaction occurs.
When businesses recognize expenses is based on how they want to run their books – whether they want to take tax deductions earlier or later or if they want to try to match expenses with their associated revenues.
Businesses tend to prefer one accounting method or the other, and that will help decide which method they should use – assuming they have a choice. A lot of businesses are required to use accrual accounting.
Let’s say a business incurred $50,000 in labor costs for the production of its products during the last quarter of 2020, but some of its employee paychecks weren’t sent out until after the last day of the year.
Based on the expense recognition principle, the company would still recognize those labor costs in 2020, since that’s when they were incurred. The work associated with those wages was performed in 2020, and the company benefited from that work in 2020, so the expense would be booked in 2020. The employee paychecks that hadn’t been cashed yet would simply be offset as a liability.
In cash accounting, on the other hand, the portion of wages not paid until after the first of the year wouldn’t be recognized until 2021. In this case, the company using cash accounting would get a delayed tax benefit by recognizing those wage expenses later. Also, there’d be misalignment between wages expenses and output created when employees were earning those wages.
In other cases, companies using cash accounting actually get tax benefits later. It depends on the transaction type and when money is changing hands.
There are two methods that businesses can use for recognizing expenses: cash and accrual. There are rules and practices governing both types of accounting, including how to use them and who can use them. Each has its own benefits and drawbacks. If you want to use the expense recognition principle, though, accrual accounting is the better option.
|Currency||When are expenses recognized?||When is revenue recognized?|
|Cash||When paid||When cash is received|
|Accrual||When incurred||When transaction occurs|
Under cash accounting, income and expenses are recognized when cash changes hands, regardless of when the transaction happened. With cash accounting, the company isn’t focused on trying to match revenue and expenses in the same period; it is instead trying to keep in its accounting thorough records of the cash flow of its accounts.
Cash accounting is often preferred because it’s simpler and easier to use. In many cases, it lets companies get the tax benefits of deductible expenses earlier than it could under accrual accounting. This is because they book expenses when they’re paid rather than when revenue starts. But not all businesses are eligible to use cash accounting.
Unlike cash accounting, accrual accounting requires businesses to record income and expenses when transactions happen, rather than when cash changes hands. Many businesses are required to use accrual accounting, including those that make over $26 million in sales in any one year over a three-year period and businesses that make sales on credit.
Accrual accounting is important because it allows businesses to match revenues with their corresponding expenses. In this way, businesses that use accrual accounting can see how they convert assets into expenses in their financials. This also makes it easier for companies to gauge the profitability of particular activities in specific periods. For more info, check out our article on cash vs. accrual accounting.
These are some examples of when businesses can benefit from accrual accounting and the expense recognition principle.
Thankfully, it’s very easy to track expenses and recognize them consistently using top accounting software. To learn about the leading options, check out our review of Intuit QuickBooks accounting software, our Zoho Books review, and our Oracle NetSuite accounting software review.
Whether you use cash or accrual accounting, accounting software lets you choose when to recognize expenses and recognize them consistently across time periods and lines of business.