Deliverable 6 - Ethical and Legal Implications

What is Expense Recognition?

Expense recognition is the process of recording expenses on the income statement. As with revenue recognition, this sounds pretty straight forward, and most of the time it is. However, there can be some ambiguities as to the precise moment and amount an expense should be recorded and in which accounting period. In order for our financial statements, in this case the income statement, to be accurate and provide useful information to managers, it is important that revenues in any given period are matched with expenses incurred in generating those revenues.

The expense recognition concept is similar to revenue recognition concept, as we will rely on the matching principle for guidance in helping us record expenses.

The matching principle states that expenses should be recognized in the same period as the revenues to which they relate. If this were not the case, then the income statement would not give us an accurate depiction of the actual net income was from month to month. It might even show inconsistencies that do not really exists that could lead management to make erroneous decisions.

Let’s take a look at the flow of expenses though the financial statements. This diagram depicts how costs affect the balance sheet and income statement.

As you can see from the diagram, things we purchase for the business (as indicated by the box on the left labeled “Cost of Items Purchased”), basically take one of two paths. (1) The balance sheet to income statement path. If we buy something, but don’t immediately use it, consume it or sell it, then the cost is recorded on the balance sheet until the point in time in which we do use it, consume it or sell, and it is at that time we recognize the expense (move it from the balance sheet to the income statement) to match expenses with revenues. (2) The direct to income statement path. If we purchase something and immediately use it consume it or sell it, the expense is recognized on the income statement immediately.

For costs that follow the first route (balance sheet then income statement), note how we use the balance sheet as kind of a “parking lot” for costs we have not yet incurred or recognized. Typical costs that follow this route are inventory, prepaid expenses and long-term assets. Think of this as “using” an item. A factory truck gets “used” over time. So, we allocate the amount “used” in the appropriate income statement period. This is what is known as depreciation in an accounting sense.

Costs that follow the second route (recognized immediately on the income statement) are usually called period costs. We will often find that some expenses are difficult to “match” with revenue. Some examples are administrative salaries, rent, and utilities. These expenses are charged to expense in the period with which they are associated. This usually means that they are charged to expense as incurred.

Regardless of how the costs flow through the financial statements, the concept and intent are the same. Make sure that expenses are recognized in the appropriate period. The appropriate period is defined as when the revenue that they earn was recorded. In other words, when we recognize a dollar of revenue on the income statement, we must recognize ALL the expenses that were incurred in earning that same dollar of revenue.