You already know that managing expenses is a critical part of small business accounting, but how do you decide when to record the different types of expenses that your business incurs? That’s where the expense recognition principle comes in.
What is Expense Recognition?
When your business incurs an expense (i.e. a cost of some kind), an asset is being used up. (Brush up on assets and their part in the accounting equation.) You need to record this expense in your company’s books, not only for your own reference, but also for reporting your financial performance to outside parties and in the case of an audit.
You will record your expenses on the income statement either at the time the expense occurs or at a later time (which we’ll explain… well… later). If we’re talking about a longer-term asset (like a piece of equipment or property) being used up and converted into an expense, this requires moving the asset from the balance sheet to the income statement. Conversely, if you’re dealing with a more short-term asset (such as office supplies, which are consumed much more quickly than your long-term assets), you can record it directly on the income statement. (Learn more about the primary financial statements.)
Following the Matching Principle
Now let’s talk about when an expense gets recognized. Following the expense recognition principle means that you will recognize expenses (i.e. recording them in your financial statements) at the same time that any revenues associated with these expenses are also recognized. This is in alignment with the matching principle, which is one of the key components of the Generally Accepted Accounting Principles (GAAP). In a nutshell, you’re making sure your expenses “match up” with the related revenues.
Let’s take a look at how this would play out using an example. Say your company sells customized clothing, and you spend $5,000 in October on the raw materials you need to make your product. You then sell the clothing made with these raw materials in November and bring in $7,500 in revenues from the sale. As per the expense recognition principle, you should wait to record the $5,000 expense until the associated revenue is received in November.
Product Costs vs Period Costs
Whether or not you recognize an expense right away or hold off until a future period can depend on which of two basic types of costs you’re dealing with: product costs or period costs.
Product costs, like the name suggests, are any costs that relate directly to a product. This would include costs like raw materials and labor. With this type of cost, you can wait to record the expense until the revenue associated with it comes in (as we saw in the customized clothing example above).
With period costs, the expense will be recorded as it’s incurred. Expenses that fall under this category include salaries paid to employees and administrative costs.
Having a handle on your company’s expense recognition policies will make it a lot easier for you (and others) to assess your financial standing.