The expense recognition principle is a major accounting concept. In this accounting principle, the accountant makes use of the accrual basis concept, where he recognizes and matches the expenses in the books in the same period as the revenues. This concept basically helps to determine when a business should consider recognizing its expenses. Hence, to learn more about this principle, read on through to the end of the article.
In this article, you will learn the expense recognition principle in general and how it works. Apart from that, you will also learn about the types of accounting that fall under the expense recognition principle. In addition to this, we will also deliberate on this concept with the help of a simple concept. Finally, we will share with you some of the major pros and cons of this accounting principle.
What Is The Expense Recognition Principle?
According to Business News Daily,
“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 is basically an accounting principle with the help of which businesses try to match their revenues that are related to those expenses. To put it simply, this method of accounting shows a business using its assets and converting these assets to expenses with more expending utilities.
When a business considers recognizing its expenses, it represents the major difference between the concepts of cash accounting and accrual accounting. A business is using a cash accounting process if it is recognizing its expenses at the time of incurring the expenses. In accrual accounting, the business recognizes its expenses and revenue related to those expenses in the same period.
How Does The Expense Recognition Principle Work?
According to AccountingTools.com,
“If a company wants to have its financial statements audited, it must use the expense recognition principle when recording business transactions. Otherwise, the auditors will refuse to render an opinion on the financial statements.”
In general cases, businesses want to spend money where they have better chances to get results. However, it is hard to tell which expenses are generating better ROI (return on investments). This is where the expense recognition principle comes into play. Businesses use this accounting tool to identify their expenses and any other associated revenues connected to those expenses.
With this information, it gets simpler for business owners to plan their investments better. Doing so, they will thus be able to maximize their ROI and must cut expenses that are not leading to the business performance.
An example can be when the business records the commissions owed to employees for certain sales at the time of the business sales rather than resorting to recording later.
What Are The Types Of Expense Recognition Principles?
Business News Daily also adds –
“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 following are the types of accounting concepts that businesses use as a part of the expense recognition principle:
1. Accrual Accounting
In this case, the business recognizes the expenses in the books at the time of matching with the revenue. For example, let’s say that the electric bills of a company are $1,000, paid for thirteen months. Then, the business will consider $12,000 for twelve months this year and the rest $1,000 for one month next year.
2. Cash Accounting
In this case, the business recognizes the expenses in the books at the time of payment and receipt. Continuing with the example above, with cash accounting, the business will recognize the entire $13,000 in the same year of the payment (business expense).
Pros And Cons Of The Expense Recognition Principle
The following are the major pros and cons of the expense recognition principle, of which you must have a good idea:
Pros Of The Expense Recognition Principle
Here are some of the major pros of the expense recognition principle that you will benefit from:
- If the company follows the accrual concept in its accounts, it saves the business from Auditing misconduct. This is because the accrual concept of accounting shows the true profitability of an organization.
- The accrual accounting concept also shows a better and more accurate financial statement as compared to cash accounting. However, the cash basis method is simpler to use.
- The accrual concept shows that the business is permanent and reflects a fair and accurate view of its financial statement. Hence, the stakeholders of a business are more focused on the accrual concept.
Cons Of The Expense Recognition Principle
Here are a few cons of the expense recognition principle that you must be aware of:
- The accrual concept requires monthly reporting from the business. Apart from that, it also needs a skilled accountant to manage such. Hence, it gets challenging for the business.
- The business reports the revenue and expenses without waiting for the actual cash received. Hence, it sometimes gets difficult for the business to pay taxes. Furthermore, small companies also face liquidity problems in this regard.
- Changing to the accrual method requires a higher cost, thus making it challenging for small businesses.
Hope this article was helpful for you in getting a better idea of what the expense recognition principle is and how it is helpful for accounting professionals and entrepreneurs. This accounting concept basically helps in determining when a business should recognize its expenses. While trying to recognize business expenses, the business itself chooses cash or accrual accounting.
The expense recognition principle basically allows the business to recognize its expenses in the same period as the business revenue connected to those expenses. Do you have any more information to add regarding this accounting principle? Share your ideas and opinions with us in the comments section below.