Expense Recognition Principle

Expense Recognition Principle Definition

Expenses recognition primarily refers to the accounting principle that follows the accrual basis concept where expenses are recognized and matched in the books in the same period as that of the revenues.

Types of Expense Recognition Principle

There are two types of expense recognition principle –

Expense-Recognition-Principle

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Examples of Expense Recognition Principle

Let’s understand this concept with the help of the following example.

Example #1

Company X paid $ 50000 to the supplier for material, which he will sell next month of $ 80000. In this case, X will recognize $ 50000 as expenses in the next month to match with revenue; otherwise, current month expenses will be high, and in the next month, the tax amount will be high. This is also done for income tax. Without this principle, income tax in the current month will be less as compared to next month.

Example #2

In some cases, matching revenue concept is not possible; therefore, expenses recognized in the period for which they are related, for example, salary, rent, electricity, administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more.

Suppose company X paid 13-month rent amounting to $ 13000, and per month rent is $ 1000.

Journal entry in 1 year-

ParticularsDebit Credit
Rent A/C………..Dr$12,000
Advance Rent A/C$1,000
To Bank$13,000

In the below scenario, X will recognize $12000  as rent for this year and balance $1000 will recognize the expense in the next year, and It will show rent under advances.

Journal Entry Next Year

ParticularsDebitCredit
Rent A/C……..Dr$1,000
To Advance Rent A/C$1,000

This year’s rent expense adjusted with advance rent.

Advantages of Expense Recognition Principles

Suppose company X paid $ 26000 for electricity for 13 months and per month electricity is $ 2000.

As per the accrual basis, electricity expense will $ 24000, i.e., $2000 per month, and it will recognize $ 2000 in the next year as it is related to next year’s expense but as per cash basis full $ 26000 will be recognized in the books in the same year.

As we can see cash basis consider $ 2000 also, which is about next year; hence, it causes less profit this year and more profit in the next year.

Those who are following accrual concepts need not report anything in notes to accounts, but if the company following a cash basis, then it has to report in notes to accounts.

Disadvantages of Expense Recognition Principles

  • It is challenging for a small company to manage its books accounts because the accrual concept required monthly reporting and which required skill employee to manage it properly.
  • The major disadvantage of maintaining books of accounts on accrual is, we will report revenue and expenses as and when it happened without waiting for actual cash received in hand; hence sometimes it is difficult to pay taxes without cash received in hand.
  • It is difficult for a small company where there is a liquidity problem. It has to pay taxes without having actual cash received.
  • It is difficult to change from one method to the accrual method because it requires a cost.
  • The cash basis recorded the transaction when it paid. Still, in reality, there can be some expenses that need to be paid in the future that why investors will not be able to make decisions about whether the company is making profit or loss.

 Limitations

  • Accrual basis principle does not suit well for a small company where there is a liquidity problem that exists, and it is also difficult for a small company at the time of payment of tax.
  • Cash Basis principle does not depict the true profitability of a company.
  • Accrual basis sometimes becomes very complicated, which is required skilled employees to maintain the same.

Change in Expenses Recognition Principles

Change in expense recognition principles is a change in accounting policy, and disclosure is required in the notes to the accounts.

This has been a guide to the Expense Recognition Principle and its definition. Here we discuss types of expense recognition principles along with examples, advantages, disadvantages, and limitations. You can learn more about from the following articles –