July 03, 2021

BooksTime  ➞  Articles  ➞  Expense Recognition Principle: Meaning and Importance

Expense Recognition Principle: Meaning and Importance

Expense Recognition Principle: Meaning and Importance

In the modern business world, all enterprises, regardless of their type and form of ownership, maintain accounting records of business operations in accordance with the current legislation. Consequently, in the course of the organization’s activities, expenses are always an inevitable part of it.

It is these aspects of the activity that are most important for all interested parties – the owners of the organization, investors, and the government. Through analysis and accounting, organizations themselves plan and control their expenses. Revenue reporting affects the decision-making of internal and external stakeholders.

The expenses of the enterprise affect the financial result of the enterprise, while the goal of any enterprise is to make a profit. Accordingly, their accurate accounting and proper planning allow both the owners and investors to ultimately achieve their financial goals of increasing profits. To achieve this, one must be familiar with the expense recognition principle.

Expense Recognition Principle: Meaning and Importance

Definition

Expenses can result from the supply or production of goods, the provision of services, or other activities of the business. Although it is always desirable to reduce the amount of expenses a company incurs, some expenses prove to be very reasonable cash spendings that increase the company’s revenue significantly. To know which expenses should be optimized and where a company can spend more, proper accounting is a must.

Once income for a reporting period has been measured and recognized, the expense recognition principle is applied to measure and recognize expenses for the same period. This is the second step in the income recognition process. The expense recognition principle requires that for any reporting period, following the recognition criteria, income is determined in accordance with the principle of accrual; then for this period, the expenses that arise in the course of receiving income for the period are determined.

The essence of this principle is that because income is earned, certain assets must be consumed (for example, raw materials), sold (for example, inventory) or services (for example, salaries) must be used. The costs of using assets and services should be recognized and accounted for in the report as an expense in the period during which the income connected to it is recognized.

Expenses can be classified as follows:

  1. Direct costs are the costs that went into the goods or services that are corresponding to the income received. Such expenses are recognized during the recognition of income arising directly as a result of the transactions or events connected with these costs.
  2. Indirect expenses would be everything associated with the implementation process and general administrative costs. These costs are recognized over the period in which they are incurred.
  3. Overhead expenses are expenses such as depreciation and insurance. These costs are apportioned evenly over the periods during which the assets are expected to generate a profit.

To account for the expenses of the period, temporary expense accounts are added to the chart of accounts.

Matching Principle

One of the most famous accounting principles is the matching principle for revenue and expenses. In simple words, it means that the reporting expenses should fall into the same periods in which the income for which these expenses were incurred is reflected.

A company, let’s say, rented a new outlet for one month due to a peak in sales during December. However, rent payments need to be paid not month by month, but with a delay: that is, December rent will need to be paid in January next year.

This is where the matching principle comes in handy, which will require that not only the revenue from December sales be reflected in accounting records for December, but also the rental expense. Is it logical? Yes, because then we will get the correct profit from the sales, as the difference between all the proceeds from the sale and all the expenses. As you can see, this accounting principle goes hand in hand with the expense recognition principle.

Share This Article
Rate the article
Rate the article
(0 voted) 0 / 5

Author: Charles Lutwidge

Talk To A Bookkeeping Expert

A bookkeeping expert will contact you during business hours to discuss your needs.

QB_enterprise
QB_Advanced
QB_Desktop
QB_PointofSale
Billcom
BBB
Hubdoc
Founders_Pledge
Mindbody
Expensify
GustoPartner
Xero
Shopify Partner
CF_Partner
wboa