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 principle 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 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 sale 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 the purpose of income tax. Without this principle income tax in the current month will be less as compared to next month.
In some cases, matching of revenue concept is not possible therefore expenses recognized in the period for which they are related for example salary, rent, electricity, administrative expenses.
Suppose company X paid 13-month rent amounting to $ 13000 and per month rent is $ 1000.
Journal entry in 1 year-
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
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 Audit report, therefore, a company following accrual concept can save themselves. 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 correct profitability of an organization.
- 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 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 pertaining to 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 true and fair view of financial statement.
- Accrual basis is very helpful in the preparation of projected financial statements. It can determine the upcoming expense and sale which provides a great tool in tax planning.
- 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 very difficult for a small company to manage its books accounts because the accrual concept required monthly reporting and which required skill employee to manage it in a proper way.
- 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.
- Cash basis records the transaction when it paid but in reality, there can be some expenses that need to be paid in future that why investors will not be able to make decisions whether the company 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 correct 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 –