It’s not uncommon for business owners to make accounting mistakes, such as recording costs in the wrong period or counting revenue they haven’t earned. While those errors may seem innocuous, they can lead to serious issues, such as underpaying your business taxes.
Knowledge is power, and having a firm grasp of accounting principles can help you avoid accounting mistakes that impact your financial statements.
One accounting guideline you'll want to pay particular attention to is the expense recognition principle. The expense recognition principle provides guidelines that help you determine the proper accounting treatment for your costs.
In this article, you'll learn the basics of the expense recognition principle and how you can apply it to your business activities.
What Is The Expense Recognition Principle?
The expense recognition principle states that companies should recognize expenses at the same time as matching revenues. The expense recognition principle is a generally accepted accounting principle (GAAP) within the U.S., established by the Financial Accounting Standards Board (FASB).
A close partner to the expense recognition principle is the revenue recognition principle. Under the revenue recognition principle, organizations recognize sales revenue when earned.
Organizations that follow accrual accounting instead of cash accounting use both the revenue and expense recognition principles in their financial statements.
Why Is Expense Recognition Crucial For Startups?
When you keep meticulous records of your company's financial transactions, you'll find it easier to explain your company's financial health to stakeholders.
Stakeholders include customers, employees, vendors, investors, and lenders. Your stakeholders want to understand your company's financial performance, and they'll use the information to make important decisions that impact your business.
Proper expense recognition is a major part of your company's financial statements. You may over or underpay your tax liability if you incorrectly recognize expenses. Plus, you won't be able to make informed financial decisions for your business since you won't have the correct data.
Key Concepts And Guidelines For Expense Recognition
You'll need to understand a few critical concepts of expense recognition methods. Understanding the guidelines helps you avoid mistakes that can lead to inaccurate accounting. Here are three components to become familiar with.
Matching Principle And Accrual Accounting
Expense recognition follows the matching principle, which asserts that companies should record revenue and the associated expenses from a sale at the same time. It's a basic tenet of accrual accounting, where companies record transactions when they occur. In contrast, organizations that follow a cash basis only record revenues and expenses when money changes hands.
Criteria For Recognizing Expenses
Recognizing a cost under the expense recognition principle starts with the related sales transactions. When a company meets the criteria for recognizing a sale, it should simultaneously recognize related expenses associated with the sale.
SaaS companies follow a slightly different model for recognizing expenses since they usually don't carry inventory. They'll recognize expenditures associated with selling their SaaS product as a cost of sales. Any expenses not directly attributed to a sale fall under regular operating expenses.
Timing Of Expense Recognition
Recognition of expenses occurs at the same time as corresponding revenue. If the company can't directly associate an expense with a sale, it typically takes a systematic approach to record expenses.
Common Challenges In Expense Recognition
It's not always easy to allocate expenses directly with revenues. Some costs occur regardless of whether a company makes a sale. In other cases, you may be unable to determine an exact expense amount. Here are a few obstacles you may face with expense accounting methods.
In most cases, it's easy to categorize an expense. Rent, employee wages, and cost of goods sold are pretty straightforward. You should be able to determine where to record them in a journal entry. However, occasionally, you may encounter a cost that's not typical for your business.
Some businesses use a miscellaneous expense account to record irregular costs. If you choose to incorporate miscellaneous expenses into your general ledger, ensure there is no other place to record the expenditure. You should use it very rarely.
Another expense categorization issue arises when the company can't recognize a sale but receives cash in advance. In that case, the company will record a deferred revenue liability until it provides the services or products requested. Deferred revenue is typical in SaaS companies.
Accruals And Estimates
Sometimes, you'll need to record an expense for a transaction where you don't know what the final cost will be. For instance, if your organization is a party to a lawsuit, you can't be sure of the outcome. Instead, you'll need to use accrual entries to estimate your expenses.
If you must estimate an expense, seek documentation where possible. In the case of legal fees, you could speak with your attorney and ask them to provide their opinion. Your attorney can make an informed estimate of the costs you'll incur.
The source of your estimates will vary depending on your expense type. You can look to prior similar bills, contracts, or external parties for help estimating an expense accrual.
Compliance And Regulations
To comply with U.S. GAAP, you must follow the expense recognition principle if you use accrual-based accounting. Failing to adhere to the principle can lead to problems with your financial statements and tax returns.
Most companies undergo financial reviews, even if they aren't public corporations that trade on stock exchanges. Financial reviews help to ascertain the validity of a company's books. Investors and lenders will request reviewed financials (and sometimes audited ones) before they provide funding to business owners.
Your organization's tax return sources information from your financial statements. If your financial statements are incorrect, you may underpay your taxes. You may incur unexpected fines and penalties even if the underpayment is accidental. It's good practice to have accurate documentation and financials you can provide in case the IRS decides to audit your company.
Streamline Expense Recognition With Modern Accounting Software
While accounting for expenses may sound complex, the good news is that the world is way beyond the accounting techniques of prior decades. Handwritten journal entries recorded in double-sided notebooks are a thing of the past. Today's companies rely on modern accounting software that handles much of the process for you. With the right tools, keeping your books entirely free of errors is possible.
Could you use some help accounting for your company’s expenses? Explore the software options available that can automatically categorize your costs, saving you time and improving the accuracy of your financial statements.