Expenses are defined as outflows of assets or incurring of
liabilities (or a combination of both) during a period as a result of delivering or producing goods
or rendering services. It follows that recognition of expenses is related to
net changes in assets and earning revenues. The approach for recognizing expenses is, “Let
the expense follow the revenues.” This approach is the expense recognition principle.
For example, companies recognize expenses not when they pay salary
or make a product, but when the work or the product in fact contributes to
revenue. Thus, companies match expense recognition to revenue recognition. By
matching efforts (expenses) with accomplishment (revenues), the expense
recognition principle is implemented. Various expenses, however, are tricky to correlate with revenue,
i.e depreciation. As a result, some other rational and systematic approach must be developed.
Costs are usually classified into two categories: product costs and period costs. Product costs,
such as material, labor, and factory 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 salaries and other
administrative expenses are recognized when they are incurred. This approach is commonly referred to as
the matching principle. However, there is some debate about
the theoretical validity of the matching principle. A key concern is that matching allows companies to defer
certain costs and treat them as assets on the balance sheet even though these costs may not
have future benefits. If abused, this principle permits the balance sheet to become a “dumping
ground” for unmatched costs.