In today's business world, the expense recognition principle plays a vital role in maintaining a company's financial integrity. This is especially true for fast-growing hardware-centric and procurement-heavy companies, where accurate financial statements are crucial to their success.
With the constant fluctuation of funding and the challenge of managing operations, it's essential to implement a generally accepted accounting principle that properly records expenses and revenues during the same accounting period.
In this blog post, we will break down the expense recognition principle, explaining its three key elements, and answer common questions such as "what is the revenue recognition principle?" By the end, you will have a clear understanding of why fast-growing engineering startups need to apply this principle in their accounting cycles to maintain their financial health and organizational efficiency.
What is the Expense Recognition Principle?
The expense recognition principle believes that a company's expenses should be recognized and recorded during the same financial accounting period as its revenues. It may also be referred to as the matching principle.
In the financial reporting realm, it is directly associated with accrual accounting or when revenues and expenses are recognized before transactions occur. This is the opposite of cash accounting, or when companies record transactions when payment is received.
3 Elements of the Expense Recognition Principle
- Cause and Effect
- Instant Recognition
- Allocation
Cause and Effect
Cause and effect occur when it is clear how costs correlate with revenue on a balance sheet.
The cause-and-effect method records accrued expenses and goods sold during a given accounting cycle. An accountant's financial reporting should list expenses and sales during the same month, even though accrued expenses come before sales.
In other words, in financial accounting, cause and effect is the linking of costs and revenue to the same financial statements, even if they didn't occur during the same month.
Example:
When an employee earns a commission, it is following a sale to a customer after they pay with their credit card. Therefore, this accounting principle states that the commission and sale should be recorded during the same period on a financial statement, even though the sale occurs before the commission is in hand.
Instant Recognition
Sometimes there is no clear link between costs and revenue during an accounting cycle. They also do not benefit from future financial accounting periods. This element of expense recognition asserts that these costs should be recognized and recorded immediately after allocating funds.
Example:
One example of instant cost recognition would be paying an employee severance after they leave the company. This is always done after termination.
Allocation
Without a direct link between cost and revenue (cause and effect), accountants have to apply other techniques during accounting periods. For instance, allocation occurs when costs benefit more than one financial period but expire over time.
Example:
Many engineering startups will possess a piece of equipment that can last for many years. But it's difficult for an accountant to determine how much annual revenue this one cost brings in. Thus, accountants use a rational allocation technique that breaks up the cost and spreads it among different accounting cycles. If the company was tracking the correlation between cost and revenue for a piece of machinery, this would be known as tracking depreciation of assets.
What is the Revenue Recognition Principle?
Similar to its expense counterpart, the revenue recognition principle declares that all cash flow, accounts receivable, and other assets should be recorded at the same time that a client receives a good or service. It doesn't mean that a company should wait to have "cash in hand."
This means it's important to have a clear understanding of when the company has fulfilled its obligation. Only then should it be recorded on a financial statement — after the goods are sold.
A small-scale example of using the revenue recognition principle would be subscription services. When customers subscribe to receive goods and services, their income statement often won't reflect the charge until later in the month.
However, the idea is that there is still a guarantee for revenue for the company. Pre-authorizing a credit card charge ensures the company receives payment, even though a client gets to enjoy services before they pay. Later in the month, they will see the charge come through on their income statement from their bank.
Of course, engineering startups will utilize the revenue recognition principle on a much larger scale. The International Accounting Standards Board declares that revenue recognition occurs when:
- It is probable that any future economic benefit associated with the item of revenue will flow to the entity.
- The revenue can be measured with reliability.
- The seller has transferred to the buyer the significant risks and rewards of ownership (goods sold).
When to Use the Expense Recognition Principle
For the sake of financial organization and accuracy, a company should apply this principle in different areas of operation.
- Sales: Revenue should be recorded immediately after a sale, not when the money is received.
- Wages: Accrual accounting is a means for companies to recognize wages during working periods and when work is performed. Because they are a guarantee, expenses are recorded and recognized before employees receive wages.
- Bonuses: Extra income for employees should be recorded in the books when the employees earn it, not when they are handed a check.
- Depreciation: Accountants should always record depreciation during the years the asset is used.
- Purchasing supplies: Supply expenses should be recognized when the company uses them, not when they are purchased.
Key Takeaways
- Fast-growing companies should use the expense recognition principle during every accounting period.
- This principle uses accrual accounting(expenses recorded at the moment of a transaction) which differs from cash accounting (expenses recorded after payment clears).
- The International Accounting Standards Board favors the expense recognition method and accrual accounting. They believe it is a better way to achieve accurate measures of profits and expenses.
Final Summary
The expense recognition principle is a crucial component of accounting that fast-growing hardware-centric and procurement-heavy startups should implement in their accounting cycles. This principle asserts that a company's expenses should be recorded during the same financial accounting period as its revenues, directly associated with accrual accounting. For hardware-centric startups that deal with costly and technologically-advanced products like drones, vehicles, and robots, this principle is essential to maintain their financial integrity.
The article breaks down the expense recognition principle into three key elements, namely cause and effect, instant recognition, and allocation. The cause-and-effect method links costs and revenue to the same financial statements, even if they didn't occur during the same month. Instant recognition applies when there is no clear link between costs and revenue during an accounting cycle that doesn't benefit from future financial accounting periods. Allocation occurs when costs benefit more than one financial period but expire over time. For instance, this technique tracks depreciation of assets, and it spreads the cost among different accounting cycles.
The revenue recognition principle is also discussed, emphasizing that all cash flow, accounts receivable, and other assets should be recorded at the same time that a client receives a good or service. It's important to have a clear understanding of when the company has fulfilled its obligation before recording it on a financial statement, after the goods are sold. The International Accounting Standards Board declares that revenue recognition occurs when any future economic benefit associated with the item of revenue will flow to the entity, and the seller has transferred to the buyer the significant risks and rewards of ownership.
Fast-growing engineering startups can use the expense recognition principle during every accounting period in different areas of operation. For instance, revenue should be recorded immediately after a sale, not when the money is received. Accrual accounting is a means for companies to recognize wages during working periods and when work is performed. Expenses are recorded and recognized before employees receive wages. Extra income for employees should be recorded in the books when the employees earn it, not when they are handed a check. Accountants should always record depreciation during the years the asset is used, and supply expenses should be recognized when the company uses them, not when they are purchased.
In conclusion, the expense recognition principle is a vital accounting component for hardware-centric and procurement-heavy startups to maintain their financial health and organizational efficiency. Accurate financial statements can avoid inefficiencies and stress for finance, accounting, and procurement teams. By implementing the expense recognition principle, startups can achieve accurate measures of profits and expenses, thus optimizing their business operations.
