What principle states that the timing of expenses be identified to the period in which they are incurred as opposed to when they are actually paid?

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Expense recognition is a key component of the matching principle; one of the 10 accounting principles included in Generally Accepted Accounting Principles (GAAP).

The expense recognition principle, following matching principles rules, states that expenses and revenues should be recognized in the same accounting period.

Overview: What is the expense recognition principle?

Similar to the revenue recognition principle, the expense recognition principle states that any expense that your business incurs should be recognized during the same period as the corresponding revenue.

Part of the matching principle, the expense recognition principle is only used in accrual accounting, since accrual accounting recognizes both revenue and expenses when they occur or when they are earned. This is different from cash accounting, which recognizes revenues and expenses when money changes hands.

How the expense recognition principle works

The expense recognition principle uses the same method as the revenue recognition principle. For example, Sara purchases 150 chairs in January. The cost of the chairs is $3,000, but Sara will not acknowledge the expense of purchasing the chairs until they are sold.

Here is the journal entry that Sara would make to record her initial purchase:

In the above journal entry, Sara would debit her inventory account, because she has added inventory in the amount of $3,000, while crediting her cash account, because she paid for the chairs immediately.

Notice that we have not yet expensed anything. If Sara did not record her inventory total properly, the amount of inventory stated on her balance sheet would be inaccurate.

In February, Sara sells all 150 chairs for $6,000. In order to follow the expense recognition principle as well as the matching principle, Sara will need to record the expense related to purchasing the chairs as well as the revenue earned in February from selling the chairs.

This will ensure that both income and expenses are recorded in the same month.

Looking at the journal entry above, you can see that Sara recorded her total payment of $6,000 in her cash account as a debit, since her cash account was increased when the money was received.

The cost of goods sold account was also debited, which indicates the expense incurred when purchasing the inventory in January.

Revenue is increased, or credited, since $6,000 was received from the purchase of the chairs, and finally, the inventory account was decreased by the amount of inventory sold, which was all 150 chairs. If revenue was not recorded properly, Sara’s income statement for the month of February would have been inaccurate.

Using the example above, let’s say that Tim, Sara’s salesperson, receives a 10% commission on sales. Since Tim sold all of the chairs for a total of $6,000, he is owed a commission of $600 (10%) on the sales.

Even though Tim will not receive his commission until March, the expense should still be tied back to the sales revenue received in February. In order to properly account for the commission in the correct month (February), Sara will need to accrue the commission expense:

By recording the above journal entry, Sara has recorded the commission expense in the correct month, even though it won’t be paid until March. When it is paid, Sara needs to remember to reverse the accrual entry, or her commission expense will be overstated.

What are the methods to recognize expenses?

While the majority of business expenses fall under the cause-and-effect method, which easily matches revenues and expenses like the example above, there are other methods used to classify expenses that occur that cannot be tied to a particular revenue.

Here are the three main methods that are used to recognize expenses properly:

Method #1: Cause and effect

The journal entries above illustrate the cause-and-effect method of expense recognition. For instance, the expense of the chairs purchased in January are clearly linked to the revenue earned in February when those same chairs were sold.

In any sales transaction, cost of goods sold is directly related to the revenue earned by selling goods to customers. Any commission earned by a salesperson would also fall under the cause and effect method, since the commissions earned are directly tied to the chair sales.

Method #2: Systematic and rational allocation

It can be difficult to assign an expense to a particular revenue source, especially when purchasing items such as factory equipment. However, when equipment is purchased, you will expense the usage of the equipment over its useful life through depreciation.

For example, In February, Sam purchased a $10,000 machine for his factory. While he cannot tie the expense to a specific revenue source, the machine will be helping to produce revenue throughout its useful life, which is estimated at seven years.

In order to properly account for that expense, Sam will need to depreciate the cost of the equipment for the next seven years.

This first journal entry above shows how to record the initial expense.

The next journal entry above shows you how to expense the machinery purchased over its useful life, which is seven years. This journal entry would be recorded each month while the machinery is still being used until the end of its useful life, or until the machinery is retired or sold.

By recording depreciation monthly, you will be able to tie the expense of the machinery to the revenue earned by the use of the machinery.

Method #3: Immediate recognition

Immediate recognition is perhaps the easiest method of expense allocation, since it’s done on a regular basis. Immediate recognition is used for all of your period costs, which include general operating expenses, administrative expenses, utility costs, selling costs, sales commissions and any other incurred expenses.

These expenses are typically recognized immediately, since in most cases it’s difficult, if not impossible, to tie any future revenue or other benefits directly to these expenses. These period costs are immediately recognized rather than recognized at a future date.

Expense recognition is a key component of accrual accounting

If you use accrual basis accounting, you should also be using the expense recognition principle. Part of the matching principle, the expense recognition principle states that expenses should be recognized in the same period as the related revenue.

If expenses are recognized when they are paid, you are using cash basis accounting. Recognizing both revenue and expenses properly ensures that your financial statements will accurately reflect your business.

If you’re still tracking revenue and expenses manually or by using spreadsheets, we recommend that you check out The Ascent’s accounting software reviews to automate the process and make your life a lot easier.

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Accrual basis accounting is one of two leading accounting methods and the preferred bookkeeping method for providing an accurate financial picture of a company’s business operations.

Accrual basis accounting recognizes business revenue and matching expenses when they are generated—not when money actually changes hands. This means companies record revenue when it is earned, not when the company collects the money. It also means recognizing expenses when the company incurs the liability for them, not when it pays them.

Key Takeaways

• Accrual basis accounting creates a more accurate view of a company’s financial status by recording revenue when it is earned and expenses when they are incurred—effectively matching revenue with expense.
• Under this method, companies record revenue and expenses using balance sheet accounts like accounts receivable, accounts payable, prepaid assets and accrued expenses.
• Cash basis accounting is a viable alternative for some small businesses. It generally makes bookkeeping simpler.

What Is Accrual Basis Accounting?

Accrual basis accounting combines two key accounting principles: the matching principle and the revenue recognition principle. The matching principle says that expenses should be recognized in the same period as the revenue they help generate. The revenue recognition principle states that revenue should be recognized when it is earned or realized, i.e. when a business performs the actions that entitles it to the revenue.

Accrual accounting generally makes the relationships between revenue and expenses clearer, providing better insight into profitability. It also offers a more accurate picture of a company’s assets and liabilities on its balance sheet. For these reasons, accrual basis accounting is the only method allowed under General Accepted Accounting Principles (GAAP) and is required by the Securities and Exchange Commission (SEC) for publicly traded companies.

How Does Accrual Accounting Work?

In accrual accounting, a company recognizes revenue during the period it is earned, and recognizes expenses when they are incurred. This is often before—or sometimes after—it actually receives or dispenses money.

Accrual accounting works by recording accruals on the balance sheet that act like placeholders for cash events. For example, accounts receivable is an asset account that reflects revenue a company has earned but hasn’t yet been paid for. Similarly, accounts payable is a liability account that reflects amounts the business owes but hasn’t yet paid.

Accrual vs. Cash Accounting

The alternative to accrual accounting is called cash accounting.

What Is Cash Accounting?

Cash basis accounting tends to be used by small businesses and organizations that pay taxes via their owner(s) personal tax returns. Under the cash basis method, revenue and expenses are recorded based solely on cash flow. Revenue is reflected when the company receives cash from a customer, and expenses are recorded when cash is paid out. This makes bookkeeping under the cash basis accounting method very straightforward and tracking cash flow simple.

The timing of when revenue and expenses are recorded can result in big swings in earnings from reporting period to the next. Since accrual accounting doesn’t factor in when money actually changes hands, it reduces the impact of timing on a company’s financial records. For instance, consider a software company that sells a five-year subscription to its solution and receives the full payment as a cash sum at the start of the subscription. With cash-based accounting, it would record all the revenue during the first period and nothing for the next five years, which could lead to vastly different numbers in two consecutive reporting periods. With accrual-based accounting, the company spreads out that revenue over the length of the subscription to smooth out the impact of that transaction.

Tax Implications

The differences between accrual and cash accounting also have significant tax implications. For example, a potential tax consequence of accrual accounting is that tax payments may be due on revenue that has been recognized, even though the company has not yet received the cash for some of those transactions.

Examples of Accrual Accounting

Revenue Example: A simple example of accrual accounting for revenue is when a company makes a sale to a customer on trade credit, meaning the buyer pays the seller within a set period of time after the transaction. In this case, revenue is earned before cash is received—primarily when goods change hands or a service has been performed.

Tom’s Services delivered IT services worth $5,000 to customer Smith’s Computers on February 10. Tom’s Services sends Smith’s Computers a bill when it produces invoices at the end of that month, on February 28—and if you’re using a cloud-based accounting system, the revenue is recognized when the transaction is recorded.

Tom’s Services invoice terms require payment within 30 days. Smith’s Computers sends a check to Tom’s on March 15, which is deposited the same day by Services Inc.

Here are Tom’s Services accounts receivable and cash journal entries for this transaction:

Expenses Example: A common example of accrual accounting for expenses is when a company buys inventory on credit.

Sport’s World, a sporting goods store, receives $5,000 worth of soccer balls from manufacturer Soccer Experts on March 1, and stocks them on its shelves in advance of the soccer season. Sport’s World receives an invoice from Soccer Experts on April 5, which it pays on April 10.

Sport’s World accounts payable and cash journal entries for this transaction are:

Other examples: There are many other ways revenue and expenses are recognized with accrual accounting. A few other use cases:

• If annual or multi-year contracts, memberships or subscriptions are paid in a single lump sum, the revenue or expense is spread across multiple periods over the life of the contract or subscription.
• For payroll, vacation or employee benefits that accumulate between payroll cycles, the company recognizes each expense during the period it applies to, even though it pays the expense later.
• When utilities or rent are billed after the period to which they apply, the company accrues the expense during the period that it uses the utilities or rented property.
• For income tax or sales tax due on revenue, the company recognizes the tax during the same period it recognizes the revenue, even though it pays the tax when required by the IRS.
• Interest on loans is recorded during the period the principal is outstanding, even though it is paid at a later date.

When to Use Accrual Basis Accounting

Accrual accounting must be used for any regulatory filing that requires GAAP, such as a company’s annual 10-K filing to the SEC. Most investors, lenders and financial institutions require GAAP financial statements when evaluating a business, which is a major reason why accrual accounting is the more popular method.

However, a few exceptions do exist, largely around income taxes. The Internal Revenue Service (IRS) allows small businesses with less than $25 million in annual revenue to use either accrual or cash basis accounting. Sole proprietors, partnerships and S-Corps are also allowed to use cash accounting. Note that changing your accounting method requires additional filing requirements with the IRS.

Advantages of Accrual Accounting

Accrual accounting is the preferred method of accounting for most businesses because it offers a more accurate representation of a company’s finances. Investors and lenders may require this method, and even if they don’t, the consistency of key metrics could make your business look more stable and increase the chances of receiving funding. Additionally, accrual accounting makes you GAAP compliant, which is a best practice, and could become important down the line.

Even startups that start out using the cash method due to its simplicity, tend to eventually move to accrual basis accounting when it comes time to apply for outside funding. So even if you don’t follow this standard now, you will likely have to in the future.

Is Accrual Accounting Right for Your Business?

If your business relies entirely on cash payments, both for revenue and for expenses, then accrual accounting may not be right for your business. For most other businesses—those that extend credit to customers or use credit with their suppliers—accrual accounting gives a more accurate picture of their overall financial health. In general, the greater the lag in payment time, the stronger the argument for accrual based accounting. Products-based businesses that carry inventory, even if they’re small, usually use accrual accounting because the cash method doesn’t properly account for cost of goods sold and sinks gross profit.

In addition, any companies with more than $25 million in revenue or that are publicly traded must use accrual accounting. So once your business reaches a certain stage, this accounting method is a requirement.

How Does Accounting Software Help With Accrual-Based Accounting?

One of the biggest reasons businesses hesitate to use accrual accounting is the time and effort required to maintain the books and records. It is more complex to manage accounts receivable, accounts payable and prepaid or deferred assets than to simply track cash in and cash out under the cash basis method. Additionally, the accrual method requires companies to close the books more frequently (i.e. monthly, rather than annually). Further, companies generally manage subsidiary ledgers like accounts receivable and accounts payable more frequently, on a weekly or biweekly basis.

This potential obstacle to adopting accrual accounting is greatly reduced by implementing accounting software, which can automate and streamline the process, reducing errors and staff cost. Recurring journal entries, subsidiary ledger reconciliations and balancing—all key components of accrual accounting—are included in the core functionality of most accounting software and simplify accrual accounting.