What Is the Expense Recognition Principle?

What is the expense recognition principle?

The expense recognition principle holds that expenses and their associated revenues should be acknowledged and recorded in the same accounting period. This accounting rule helps business owners connect expenses to revenues. It’s part of the “matching principle” — one of the generally accepted accounting principles (GAAP) — and an essential element of accrual accounting. 

Businesses that use accrual accounting abide by the expense recognition principle. This accounting method centers on the idea that expenses should be recognized during the same period as the revenue with which they are associated. For example, say you create a product that earns $100,000 in a month. Its associated expenses, such as production costs and the salesperson’s commission, would be recorded in the same period as its revenue. 

Cash vs. accrual accounting

To understand the expense recognition principle, it’s essential to know the difference between cash and accrual accounting. Rules and practices govern both accounting types, including how to use them and who can use them.

• Cash accounting: Under cash accounting, income and expenses are recognized when cash changes hands, regardless of when the transaction happened. The company doesn’t try to match revenue and expenses in the same period. This method is often preferred because it’s simple. In many cases, it lets companies get the tax benefits of deductible expenses earlier than they could under accrual accounting. This is because they record expenses when they’re paid instead of when revenue starts. However, not all businesses are eligible to use cash accounting.
• Accrual accounting: Accrual accounting requires businesses to record income and expenses when transactions happen, not when cash changes hands. Many businesses must use accrual accounting, including those with over $26 million in annual sales over three years and businesses that make sales on credit. Accrual accounting allows businesses to match revenues with their corresponding expenses. Businesses that use accrual accounting can see how they convert assets into expenses in their financials. This also makes it easier for companies to gauge the profitability of particular activities in specific periods. 

With accrual accounting, a business abides by the expense recognition principle and recognizes revenue and expenses in the same period. However, if a business recognizes expenses when they’re incurred, it’s using cash accounting. 

Exactly when a business chooses to recognize an expense is based on how it wants to run its books. Owners will look at whether they want to take tax deductions earlier or later or if they want to match expenses with their associated revenues.

How does the expense recognition principle work?

With the expense recognition principle, the goal is always to match your business’s revenue and expenses in the same period. 

Under the expense recognition principle, if work is performed and you haven’t paid for it, you record it as an expense and accrue it as a business liability. Conversely, if you have paid for something but haven’t received the associated benefit (revenue), you would book that benefit as an asset (a prepaid expense). 

In contrast, if your business uses cash accounting, it will recognize revenue or expenses when cash changes hands, whether going in or out, instead of when a transaction occurs. 

Example of the expense recognition principle

Let’s say a business incurred $50,000 in labor costs for the production of its products during the last quarter of 2023. However, some employee paychecks weren’t sent out until after the last day of the year. 

Based on the expense recognition principle, the company would still recognize those labor costs in 2023 because that’s when they were incurred. The work was performed in 2023, and the company benefited from that work in 2023. Therefore, the expense would be booked in 2023. If employees haven’t yet cashed their paychecks, that money would simply be offset as a liability. 

On the other hand, with cash accounting, the portion of wages not paid until after the first of the year wouldn’t be recognized until 2024. In this case, a company using cash accounting would get a delayed tax benefit by recognizing those wage expenses later. There would also be a misalignment between wage expenses and output created when employees were earning those wages.

In other cases, companies that use cash accounting actually get tax benefits later. It depends on the transaction type and when money changes hands.

When to use the expense recognition principle

Consider the following examples of when businesses can benefit from accrual accounting and the expense recognition principle:

• Salaries and wages: Accrual accounting lets businesses recognize wage expenses when work is performed, not when paychecks are cashed.
• Sales commissions: If companies pay commissions tied to sales, those commissions should be recognized when the sales occur.
• Employee bonuses: Employee bonuses should be booked in the year they are earned rather than when checks are issued.
• Depreciation: Asset depreciation must occur in the year the assets were used and part of their utility was expended.
• Purchase of supplies: If a business buys supplies to use during a later production period, that expense should be booked when the supplies are used, not when they’re purchased.
• Liability for services provided: Once you’ve received the benefit of work performed — even unpaid — the expense recognition principle says to incur those expenses and accrue them as liabilities.

Best accounting software for expense recognition

Whether you opt for the cash or accrual accounting method, the best accounting software can help you accurately record expenses and recognize them consistently across periods and lines of business. 

• QuickBooks Online: QuickBooks Online is a trusted accounting tool that many businesses rely on to streamline and consolidate their expense management processes. We like that it’s compatible with most major banks and boasts an automatic expense organization tool. Read our QuickBooks Online review to learn about its comprehensive and shareable expense report features and robust accounting reports. 
• Zoho Books: Zoho Books excels at expense management. Our Zoho Books review explains how this platform eliminates guesswork by tracking recurring expenses, auto-scanning bills and distilling critical information.
• Oracle NetSuite: Oracle NetSuite targets every aspect of the expense cycle with robust expense submission and management tools. NetSuite is a one-stop shop for expense management, allowing you to enter and consolidate expenses by project, approve new business expenses, compile reporting data and more. Our Oracle NetSuite review details this platform’s easy-to-use mobile features and compatibility with major banks and credit cards.

Streamlining expense management for the long term

As your business determines how to manage its expenses, it’s crucial to examine the big picture. One of the best ways to do so is to set a foundation of systems, principles and tools for your expense management process. By accurately tracking expenses and relying on concepts such as the expense recognition principle, you’ll set yourself and your team up for success. 

Jane Godiner contributed to this article.