Expense Recognition

Expense recognition is an essential element in accounting because it helps define how profitable a business is in an accounting period.

Learning Objective

Calculate the ending balance of an income statement account and discuss how the proper recognition of expenses affects a company's income

Key Points

Expenses are outflows of cash or other assets from a person or company to another entity.
Expenses can either take the form of a decrease in a business' cash or assets, or an increase in its liabilities. It is important to note that cash or property distributions to a business owner do not count as expenses.
The accounting method the business uses determines when an expense is recognized.
If the business uses cash basis accounting, an expense is recognized when the business pays for a good or service.
Under the accrual system, an expense is recognized once it is incurred.

Terms

accrual basis accounting
A method of accounting where income is not recorded until earned and expenses are not recorded until incurred.
cash-basis accounting
A method of accounting where income is recorded when cash is received and expenses are recorded when cash is paid.
expense
In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

Full Text

Recognition of Expenses

Expenses are outflows of cash or other valuable assets from a person or company to another entity. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners' equity.

A Sample Income Statement

Expenses are listed on a company's income statement.

The International Accounting Standards Board defines expenses as follows: "Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. "

An important issue in accounting is when to recognize expenditures. When a business recognizes an expenditure, it records the amount in its financial records. The expenditure offsets the income the business earned and is used to calculate the business's profit.

This makes the timing of expenses and revenues very important. By shifting the timing of when expenses are recognized, a company can artificially make its business appear more profitable. Therefore, the accounting standards institute has established clear guidelines to minimize any subjective judgment regarding when to recognize expenses. Thus, the accounting method the business uses depends on when an expense is recognized.

Cash Basis Accounting

If the business uses cash basis accounting, an expenditure is recognized when the business pays for a good or service. Generally, cash basis accounting is reserved for tax accounting, not for financial reports.

Accrual Basis Accounting

Most financial reporting in the US is based on accrual basis accounting. Under the accrual system, an expense is not recognized until it is incurred. This means it is unimportant with regard to recognition when a business pays cash to settle an expense.

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Differences Between Accrual-Basis and Cash-Basis Accounting

Current Guidelines for Expense Recognition

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