Expenses are a crucial part of any business just like the revenue. Typically explained it’s the outflow of assets to write off any liability or a combination of both occurred during the process of manufacturing, delivering or rendering of service.
This concludes that the expense recognition is linked to the net value and the changes that occur in assets and revenues. The assets manufactured and sold to generate revenue also incur some expenses.
The accounting standards require all the companies to record and match all their revenues and expenses and do a contrast to them so as to determine profit or income for any provided accounting period.
Following are the basic concepts to determine revenue and expenses
Revenue is recognized, when it’s earned or recognized. (Realized stands for the receipt of cash whereas realizable means there is a prospect of receipt of cash in future).
The expense is recognized once there’s already the recognition of revenue. The principle further defines as the matching principle.
Important concepts of Revenue and Expense
When the cash basis accounting system is employed, expenses and revenues are recognized as under
Revenue is recognized only when the cash against the service or product is received.
The expense is recognized only when there is a cash payment to write off the liability or o pay any debt.
The timing has a significant effect on the realization and recording of expense and revenue.
There are two types of revenue and expense:
- Accrued Revenue denotes revenue before the actual receipt of cash.
- Deferred Revenue shows revenue that’s recorded after the cash is received.
- Accrued Expense is the expense that’s unpaid, and cash payment stands due.
- Deferred Expense is the expense that’s recognized after the cash payment.
The Matching Principle
The matching principle says that the expenses are only to be recognized when;
- The ownership of the goods has been transferred which comes after the sales or service has been rendered.
- The revenues arising out of those expenses have been realized (based on cause and effect).
For instance, a company makes the chair out of woods. The company acquires wood in the month of August and the payment is made right after the acquisition. There are 100 chairs made out of that wood, which is now sold in the month of September.
While all the cost beard on this wood were recorded in the month of August, the expense isn’t fully recognized until the sale is made in September. There are companies that don’t recognize expense until unless there is revenue recognition.
For example, a company doesn’t record the expense incurred on manufacturing a product or payment of salaries unless any revenue arises out of it like the sale of good or completion of the job. It implies the cost and effect rule and is known as the matching principle.
The Impact of Timing of Revenues & Expenses
Timing has its effect on the recording of expense and revenue. There are business transactions where expense are recorded even before goods are produced or revenue is received before the job is done.
There are standardized matching and recognition principles to correctly determine the expense and revenue for any given period.
In the absence of such rules, the income statement looks flawed and can affect the actual expense and revenues of the company.
By generalizing rules for recording revenue and expenses on the completion of sales, delivery of goods and receipt of payment an Income statement is in a better position to determine and reflect the financial standing of the company.