When are expenses recognized?
February 26, 2012
Learn about three methods to recognize expenses: association of cause and effect, systematic and rational allocation, and immediate recognition.
Expenses are decreases in assets (e.g., rent expenses) or increases in liabilities (e.g., accrued utility expenses) that result from operating activities undertaken to generate revenue.
Expenses are recognized in accordance with the matching principle. This principle mandates that the expense or cost of doing business is recorded in the same period as the revenue that has been generated as the result of incurring that expense or cost. In other words, revenues reported in a given income statement should be reported along the costs (expenses) incurred in generating these revenues. In accordance with the US GAAP (Generally Accepted Accounting Principles), there are three (3) ways expenses can be properly matched against revenues:
- Association of cause and effect
- Systematic and rational allocation
- Immediate recognition
The first way to implement the matching principle is the associating cause and effect method. In accordance with this method, some expenses are presumably directly associated with specific revenues. In this case, transactions simultaneously result in both revenues and expenses, and as a result, these revenues and expenses are directly related to each other. For example, cost of goods sold is directly associated with the sales revenue. Sales commissions can also be directly matched against sales revenues. The association of cause and effect principle can be applied to transportation costs incurred to deliver goods to customers.
When there is no cause and effect relationship, some expenses can be allocated to the accounting period benefited in a systematic and rational manner. For example, the cost of manufacturing equipment is difficult to allocate to specific inventory sale transactions. As the result, the cost of equipment is systematically allocated as depreciation expense among the periods in which the equipment provides the benefit (i.e., generates revenue). The allocation scheme is based on the expected benefit. The systematic and rational allocation method can also be used to amortize intangibles and allocate prepaid costs such as insurance and rent.
When both the associating cause and effect and systematic and rational allocation methods cannot be used, expenses are recognized immediately. For example, it can be difficult to identify future benefits of some costs incurred, or for some costs no rational allocation scheme can be devised. Period costs are usually immediately recognized. Examples of costs that might be immediately recognized include utilities, routine maintenance costs, officers’ salaries, and most selling and administrative costs.
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