To recognize an expense means to report the proper amount of an expense on the income statement for the appropriate accounting period. This is accomplished by following these steps:
- When there is a cause-and-effect relationship between a company's revenues and some of its expenses, these expenses should appear on the same income statement as the associated revenues. Accountants describe this as matching expenses with revenues. For instance, a company's sales of products which are properly reported on its July income statement will cause the related expense known as the cost of goods sold to be reported/recognized on the July income statement. If the company's sales reps have earned commissions on the July sales, these commissions should also be recognized/reported as Commissions Expense on the company's July income statement (regardless of when the company pays the commissions).
- If a cause-and-effect relationship does not exist between a company's revenues and its costs, and there is no future economic benefit which can be measured, the costs should be recognized/reported immediately as expenses on the current income statement. A few examples include advertising, office salaries, interest on most loans, and research and development costs.
- When a cost has a future economic benefit which can be measured, the accountant should report the cost as an asset. Then as the future benefit expires (is used up) the cost should be systematically recognized/reported as an expense on the appropriate income statements. Some examples include the expensing of prepaid insurance premiums and the depreciation of assets used in the company's business.
Companies use adjusting entries in order for their income statements and balance sheets to be reporting the proper amounts in the appropriate accounting periods.