Expense recognition is an essential element in accounting because it helps define how profitable a business is in an accounting period.
Calculate the ending balance of an income statement account and discuss how the proper recognition of expenses affects a company’s income
- Expenses are outflows of cash or other assets from a person or company to another entity.
- Expenses can either take the form of a decrease in a business’ cash or assets, or an increase in its liabilities. It is important to note that cash or property distributions to a business owner do not count as expenses.
- The accounting method the business uses determines when an expense is recognized.
- If the business uses cash basis accounting, an expense is recognized when the business pays for a good or service.
- Under the accrual system, an expense is recognized once it is incurred.
- expense: In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue
- accrual basis accounting: A method of accounting where income is not recorded until earned and expenses are not recorded until incurred.
- cash-basis accounting: A method of accounting where income is recorded when cash is received and expenses are recorded when cash is paid.
Recognition of Expenses
Expenses are outflows of cash or other valuable assets from a person or company to another entity. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners’ equity.
The International Accounting Standards Board defines expenses as follows: “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. ”
An important issue in accounting is when to recognize expenditures. When a business recognizes an expenditure, it records the amount in its financial records. The expenditure offsets the income the business earned and is used to calculate the business’s profit.
This makes the timing of expenses and revenues very important. By shifting the timing of when expenses are recognized, a company can artificially make its business appear more profitable. Therefore, the accounting standards institute has established clear guidelines to minimize any subjective judgment regarding when to recognize expenses. Thus, the accounting method the business uses depends on when an expense is recognized.
Cash Basis Accounting
If the business uses cash basis accounting, an expenditure is recognized when the business pays for a good or service. Generally, cash basis accounting is reserved for tax accounting, not for financial reports.
Accrual Basis Accounting
Most financial reporting in the US is based on accrual basis accounting. Under the accrual system, an expense is not recognized until it is incurred. This means it is unimportant with regard to recognition when a business pays cash to settle an expense.
Current Guidelines for Expense Recognition
For an expense to be recognized under the matching principle, it must be both incurred and offset against recognized revenues.
Explain how accrual accounting uses the matching principle for expense recognition
- An expense is incurred when the underlying good is delivered or service is performed.
- If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.
- If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed.
- If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred.
- consigned good: a good sent to another person where the seller still retains ownership until ownership is transferred or the good is sold
- matching principle: An accounting principle related to revenue and expense recognition in accrual accounting.
Since most businesses operate using accrual basis accounting, expense recognition is guided by the matching principle. For an expense to be recognized, the obligation must be both incurred and offset against recognized revenues.
An expense is incurred when the underlying good is delivered or service is performed. For example, assume a company enters into a contract with a supplier for the delivery of 1,000 units of raw material that will be used to produce the goods it sells. Two weeks later, the raw material is delivered to the company’s warehouse. Two weeks after that, the company pays the outstanding obligation. Under the matching principle, the expense related to the raw material is not incurred until delivery.
Offset Against Recognized Revenues
Generally, an expense being incurred is insufficient for it to be recognized. If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.
Using the same example from above, the delivery of the raw material is insufficient to cause the cost of those goods to be recognized as an expense. The raw material will be used to make items that will be sold to the public. When the items that used the raw materials are sold, then the costs related to the raw material are recognized.
No Cause and Effect
The matching principle assumes that every expense is directly tied to a revenue generating event, such as a production of a good or service. This is not always the case. When these expenses are recognized depends on what goods or services are related to the cost in question.
If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed. So if a business produced substandard goods that it could not sell or the good becomes spoiled, the production costs would be expensed as soon as it became clear that the item could not be sold.
If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred. Examples of such costs include general administration and research and development.
Differences Between Accrued and Deferred Expenses
Accrued and deferred expenses represent the two possibilities that can occur due to timing differences under the matching principle.
Explain the difference between accrued expenses and deferred expenses
- An accrued expense is a liability that represents an expense that has been recognized but not yet paid.
- A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred.
- Oftentimes an expense is not recognized at the same time it is paid. This difference requires a business to record either an asset or liability on its balance sheet to reflect this difference in timing.
- matching principle: Expenses should be matched with revenues.
- deferred expense: A deferred expense or prepayment, prepaid expense, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.
- accrued expense: Accrued expense is a liability with an uncertain timing or amount, the reason being no invoice has been received yet.
- accrued revenue: income recognized before cash is received
Accrued expenses and deferred expenses are two examples of mismatches between when expenses are recognized under the matching principle and when those expenses are actually paid. Both are represented on the company’s balance sheet.
An accrued expense is a liability that represents an expense that has been recognized but not yet paid. Not every transaction requires an immediate exchange of cash for goods and services. Sometimes, especially when there is a prolonged history of ongoing transactions between two parties, formal invoicing and payment requirements can occur after the expense associated with the transaction has been recognized.
For example, assume a reseller receives goods from a supplier that it is able to immediately resell. However, the billing for those goods does not require payment for another month. Since the supplier delivered the goods and the reseller already generated revenues from the sale of those goods, it must recognize the associated expense. So the associated expense must be listed as a liability to be paid at some point in the future.
A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred. Deferred expense is generally associated with service contracts that require payment in advance.
For example, assume a company enters into a legal services contract that requires an upfront payment of $12,000 for a year of services. The service has not yet been delivered, so the business cannot recognize the expense yet. So the business will record a $12,000 deferred expense asset. The provider then delivers on his service each month, requiring the business to recognize the associated expense. As a result, the business must recognize $1000 in expenses each month and decrease the value of the deferred expense asset by that amount.