Expense recognition is the act of converting an asset into an expense. This is done when the utility of an asset has been consumed. Expense recognition can arise on a delayed basis, when expenditures are made for assets that are not immediately consumed. Examples of this type of expense recognition are:
When the period covered by a prepaid rent payment is complete.
When the advertising activities associated with a prepaid ad payment have been completed.
When the period covered by a prepaid general liability insurance policy is complete.
Expense recognition can also take place as soon as an expenditure is made. Such recognition may arise because the underlying utility of an acquired item was consumed within the same reporting period as the expenditure. This recognition may also arise because the cost of the acquired item falls below the capitalization limit of a business, so that the expenditure is always recorded as an expense as soon as it is incurred. Examples of this type of expense recognition are:
The purchase of office supplies
The incurrence of a liability associated with legal services already provided
The incurrence of a liability for utilities already consumed
The purchase of a laptop computer for which the cost is less than the corporate capitalization limit
Ideally, expense recognition should occur at the same time as the recognition of any revenue with which an expenditure is associated (the matching principle). For example, the expense recognition for the cost of goods sold associated with the sale of a product should be in the same period in which the sale was recognized.
When expense recognition occurs, the amount of the expense appears in the income statement, reducing the amount of profit that would otherwise be recorded. For a longer-term asset, this means that an asset is being eliminated from the balance sheet and moved to the income statement. For a shorter-term asset (such as office supplies) the asset is not present long enough to appear on the balance sheet - it is simply recorded at once in the income statement.
The timing of expense recognition is one of the more common forms of financial statement fraud, since the managers of a company may have an incentive to delay expense recognition in order to bolster the reported results of a reporting period. This situation most commonly arises when the compensation of managers is closely tied to the reported results of an organization.