An expense recognition principle is an important tool in the financial statement process. It is effective when expenses and revenues are clearly correlated, or when one expense directly affects a number of revenue areas. But when revenues and expenses do not match up, the accounting team is forced to make estimates. Consider an example: an expense for office supplies may not correspond to revenue. So the team must determine a more accurate way to account for those expenses. The matching principle applies to these cases, too.
Table of Contents
Immediate Allocation
While there are some costs that cannot be directly linked to the production of revenue or that benefit future period, it is more appropriate to recognize them immediately. For example, severance pay for fired employees would be recognized as an expense in the period the employee is terminated. Immediate allocation helps to prevent misstating profit and loss by recognizing all expenses in the same period. However, this principle can lead to a number of problems.
When the cost of a piece of machinery has a clear link to revenue, immediate allocation is the most appropriate method for expense recognition. This method allows businesses to recognize an expense for each year it is in use. The problem is, however, that some costs benefit different periods of time, such as depreciation. If the cost of a truck is spread over multiple years, it will be very difficult to determine each year’s cost separately. Instead, accountants may use a systematic and rational allocation principle to spread the cost over each period that it is used. This process is called depreciation.
Using this principle is important for many reasons. For example, it is more convenient to recognize expenses in the same period as their related revenue. For example, Sara’s doll company purchases 150 chairs for $6,000 and pays for them on March 1. After manufacturing 150 chairs, Sara would need to record the expense, revenue, and income related to those chairs. If Sara’s inventory total were not accurate, she would have an inaccurate balance sheet.
While immediate allocation may not be the best method for every business, this principle is one of the most widely used principles. Unlike other accounting principles, this principle applies to certain industries and businesses. If you are using accrual accounting, you will need to consider whether this principle is right for your company. As long as the company has an established accounting policy, it should be in line with the needs of its customers. In short, it is best to use both methods to track and report your business’s financial data.
Matching Principle
The matching principle in expense recognition relates to when expenses are recorded. Under this principle, expenses should be recorded when they are matched with corresponding revenues. For example, if company X pays a supplier $ 50000 for materials that cost $ 80000, the company should recognize the expenses in the same month as the revenue. The matching principle is not appropriate for all expenses, however. Companies should use it when recognizing sales revenue, which can be linked directly to a product, rather than period costs, which are not directly tied to a product.
The matching principle is most useful when it comes to long-term assets. This principle allows businesses to spread the cost of long-term assets over the useful life of the assets. For example, an employee making a commission from product sales may invoice customers in December. Since the cost of specialized equipment may increase over time, the matching principle allows companies to depreciate this asset over time. For example, the company might purchase $25,000 of specialized equipment that lasts for 10 years.
Revenue and expense recognition principles are closely connected, despite the difference in name. Revenue recognition is an important window into the workings of the business. Because the two concepts are related, a company’s financial statements will show more accurately when it matches expenses with revenue. The Accounts Receivable account tracks the revenue and expenses associated with a customer. Because the amount owed by the customer must be repaid within the company’s operating cycle, the money in the Accounts Receivable account usually does not accrue interest.
The matching principle is an essential concept in accrual-basis accounting. It mandates that the same period for expenses as it is for revenues. This principle prevents companies from artificially accelerating profits and ensures that all expenses are recorded at the same time. Expenses that are not matched are called accruals. The matching principle is often referred to as cash accounting. This principle is not applicable to sales that are not realized.
Consider the example of a company that has an inventory. If Sara has only a few chairs in her warehouse, the balance will not reflect any income and expenses in that month. If she sells only 150 chairs, the expense associated with the chair sale is the amount of the sales revenue. The revenue related to the chairs is determinable and collectible, and therefore, requires both cost and sales entries to be recorded in the same month.
In the example above, a business incurs $50,000 in labor costs in the fourth quarter of 2020. However, the company doesn’t send out paychecks to employees until after the end of the year, the same year the labor costs were recognized. This example illustrates how the Matching Principle works in accounting. In addition, the Company recognizes revenue when it is generated and expenses when it is paid. For example, the purchase of a machine will produce revenue. However, the lifetime of the machine will be several years, so it is a little difficult to determine whether it contributes to the revenue or not.
Revenue and expenses are tightly linked. A company may purchase fifty shirts for $5,000 but only recoup $2,000 of the cost of goods sold. If the salesperson sells those 50 T-shirts for $2,300, the company should recognize the entire cost of goods sold as an expense in the same period. Revenue and expenses should be closely linked. If one does not match, the accounting team will have to make estimates. For example, office supplies may not be directly related to revenue.
The Matching principle in expense recognition principle requires a business to recognize revenue when it is earned, rather than wait until it is paid in cash. For example, a contractor could record revenue on a monthly basis, and the customer might not pay the invoice until the next accounting period. The commission is deducted from revenue in the same manner. In other words, the Matching principle works best in situations where there is a direct cause-and-effect relationship between a cash flow and an expense.
