As per the expense recognition concept, the expenses shall be recognized in the same period as the revenues to which they relate. Further, under the accrual method of accounting, the expenses have to be reported in the income statement for the period in which:
- The expense best matches the revenue/sales.
- The expense is used or expires during this period.
- There is uncertainty in measuring the future benefits of cost.
There are two major classifications of expenses:
- Operating expenses: These involve major activity expenses for operating the business. The operating expenses include the cost of goods sold, general and administrative expenses, etc. These expenses can quickly be sorted by department and product line.
- Non-operating expenses: These expenses relate to the incidental activities of the company. Such expense includes interest expense which is not directly related to the main activity of the business.
It is concluded with respect to various accounting bodies that some expenses are difficult to correlate as administrative salaries, rent, and utilities.
These are nearly fixed for the month and sales fluctuate over the period. Hence, they are charged as expenses as and when incurred as per the periodicity concept.
To get accounts audited, the companies must follow the expense recognition concept in the gist.
It represents the purchases that are unpaid by the enterprise.
In the cash conversion cycle, companies match the payment dates with accounts receivables making sure that receipts are made before making the payments to the suppliers.
The lower the accounts payable days the better. It reflects that the company is able to realize the cash in a good fashion.
An example would be: The Bold Fashions Ltd bought textile garments from Sri Textile traders as raw materials on credit.
The Bold Fashions here got the inventory as a current asset while creating a short-term obligation on the other hand.
Accounting treatment in Financial Statements
Expenses are shown in the income statement on the debit side if the traditional format is used.
|Less: Cost of goods sold (expense)||X|
|Less: operating expenses|
|Utilities expenses etc||X|
|Less: Non-operating expense||X|
Accounts payable fall under the current liabilities section which falls under the liabilities part of the Balance sheet as shown below:
|Liabilities and capital||Amount ($)||Assets||Amount ($)|
|Shareholders’ equity||X||Non–current Assets||X|
| Other current Liabilities |
Connecting the dots
Let’s take an example of the expense of salaries. Salaries are generally paid on a fixed basis to staff monthly.
The expense recognition states that salary shall be expensed as and when accrued. Even though the salary is not paid in cash, it has to be recognized.
When it is due but not paid, it is shown in current liabilities as salaries payable as shown in the above balance sheet. It has to be noted that the same balance is also reported as the expense and as current liabilities.
Accounts payable are a subset of current liabilities which are a result of the amount payable to suppliers for the goods purchased.
So, the connection would be that unpaid and due expenses would be that expenses payable would end up in the current liabilities section along with accounts payable under the same heading current liabilities.
One additional point would be purchases engrossed in the cost of goods sold. These are in the nature of expenses but when unpaid, these become accounts payable.
In conclusion, the accounts payable and expenses only cross paths on the cost of goods explicitly sold purchases when they are unpaid and due.
These are entirely two different components of financial statements to a more significant extent.