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 –
- Accrual Basis – Under this accrual principleAccrual PrincipleAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. expense will recognize in the books as and when it is matched with the revenue. For example, telephone bills per month are $500 paid for 13 months. Under this method, $6000, which is for 12 months, will consider this year’s rest $500, which is for one month will consider next year.
- Cash Basis – Under this method of cash basis, the expense will recognize in the books when it is paid or received. Consider the above example; under this method, a full $6500 will recognize in the same year when it is paid.
Examples of Expense Recognition Principle
Let’s understand this concept with the help of the following example.
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.
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..
Suppose company X paid 13-month rent amounting to $ 13000, and per month rent is $ 1000.
Journal entry in 1 year-
|Advance Rent A/C||$1,000|
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
|To Advance Rent A/C||$1,000|
This year’s rent expense adjusted with advance rent.
Advantages of Expense Recognition Principles
- During the Audit of financial statement, if the Auditor finds books of accounts of the company has not followed the accrual concept, then Auditor may qualify the Audit report. Therefore, a company following the accrual concept can save itself. For example, as per the standard on Audit, the Auditor has to check whether the company is following the accrual concept or not. If he fails to identify, then there will be professional misconduct by the Auditor, so it is the duty of Audit to check the same.
- The accrual concept depicts the true profitability of an organizationProfitability Of An OrganizationProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance..
- Accrual concept show more accurate financial statement as compared to cash basis because cash basis recognizes when it is paid or received that may consist of the amount relating to another period also.
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.
- Stakeholders are more focus on the accrual concept rather than cash basis because accrual concept shows permanent of business and reflect the accurate and fair view of financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
- Accrual basis is beneficial in the preparation of projected financial statements. It can determine the upcoming expense and sale, which provides a great tool in tax planningTax PlanningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities..
- Cash basis method simple to use because it records the transaction when it is paid, it is generally used by the small companies and individuals.
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.
- 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 –