Expense Recognition Principle

As indicated in the discussion of financial statement elements, expenses are defined as
outflows or other “using up” of assets or incurring of liabilities (or a combination of
both) during a period as a result of delivering or producing goods and/or rendering
services. It follows then that recognition of expenses is related to net changes in assets
and earning revenues. In practice, the approach for recognizing expenses is, “Let the
expense follow the revenues.” This approach is the expense recognition principle.
To illustrate, companies recognize expenses not when they pay wages or make a
product, but when the work (service) or the product actually contributes to revenue.
Thus, companies tie expense recognition to revenue recognition. That is, by matching
efforts (expenses) with accomplishment (revenues), the expense recognition principle
is implemented in accordance with the definition of expense (outflows or other using
up of assets or incurring of liabilities).13
Some costs, however, are difficult to associate with revenue. As a result, some other
approach must be developed. Often, companies use a “rational and systematic” allocation
policy that will approximate the expense recognition principle. This type of expense
recognition involves assumptions about the benefits that a company receives as
well as the cost associated with those benefits. For example, a company like Intel or
Motorola allocates the cost of a long-lived asset over all of the accounting periods during
which it uses the asset because the asset contributes to the generation of revenue
throughout its useful life.
Companies charge some costs to the current period as expenses (or losses) simply
because they cannot determine a connection with revenue. Examples of these types of
costs are officers’ salaries and other administrative expenses.
Costs are generally classified into two groups: product costs and period costs.
Product costs, such as material, labor, and overhead, attach to the product. Companies
carry these costs into future periods if they recognize the revenue from the product in
subsequent periods. Period costs, such as officers’ salaries and other administrative
expenses, attach to the period. Companies charge off such costs in the immediate
period, even though benefits associated with these costs may occur in the future. Why?
Because companies cannot determine a direct relationship between period costs and
revenue. Illustration 2-5 summarizes these expense recognition procedures.