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Expence Recognition in Financial Accounting

The matching principle governs expense recognition. It states that all costs that were incurred to generate the revenue appearing on a given period’s income statement should appear as an expense on the same income statement. In other words, we should match expenses against revenues. Revenues are first recognized and expenses are then matched with those revenues. By doing this, the income statement contains measures of both accomplishment (revenue) and effort (expenses), thereby enabling an assessment of firm performance. The matching principle is implemented in one of three ways, explained below.

Associating Cause and Effect

One method of implementing the matching principle is known as associating cause and effect. This implies that a clear and direct relationship exists between the expense and the associated revenue. Cost of goods sold is a good example. A retail store certainly cannot generate sales revenue without consuming inventory. Salespersons’ commissions are another example. Because commissions are usually paid as a percentage of sales revenue, commission expense is tied directly to revenue.

Systematic and Rational Allocation

Another method used to implement the matching principle is systematic and rational allocation. Many costs cannot be directly linked to specific revenue transactions. They can, however, be tied to a span of years and allocated as an expense to each of those years. Sales equipment, as an example, is essential to generate revenue. However, linking the cost of each display case, piece of furniture, and the like to specific sales transactions is difficult. Instead, the equipment’s cost is systematically allocated as depreciation expense to the years during which the equipment helps generate revenue.

Immediate Recognition

The final method of applying the matching principle is immediate recognition. Some expenditures have no discernible future benefit. In these cases, the expenditure is expensed immediately. Officers’ salaries, utilities, and interest are treated in this manner.

Following case study addresses revenue and expense issues for Cendant Corporation.

Case Study 3.2

Cendant Corporation markets memberships in discount purchasing clubs. Typical subscriptions last one year. The first month is a trial membership; members pay no fee. After the first month, members are billed monthly. However, at any time during the year-long subscription period, a member can terminate the agreement and receive a refund for all amounts paid. Cendant also incurs marketing costs in attracting new members (such as mailings and phone solicitations).

Required

a. Describe two methods that Cendant could use to recognize revenue. Which method is the most conservative?

b. For each of the two revenue recognition methods described above, suggest a method of expense recognition that adheres to the matching principle.

c. Because Cendant has experienced significant accounting regularities, the SEC has forced Cendant to use certain revenue and expense methods. Which methods do you suspect these are?

Solution

a. Cendant could recognize revenue ratably over the 11-month period following the trial membership. This method is supported by the fact that Cendant provides the services over this period. However, Cendant would also need to establish an allowance for its estimate of the number of memberships that will be canceled. Alternatively, Cendant could recognize revenue at the end of the twelfth month, when cancellation is no longer possible. This method defers revenue recognition as long as possible, requires no estimates, and is the most conservative.

b. The first method of revenue recognition would be accompanied by deferring the marketing costs and expensing them over months two through 12. The second method would be accompanied by deferring the marketing costs and expensing them at the end of the twelfth month. In both cases, a portion of the marketing costs should be expensed more quickly to reflect the canceled subscriptions.

c. The SEC has required Cendant to use the most conservative methods possible. Accordingly, revenue is recognized at the end of the twelfth month. Expenses are recognized when incurred because they cannot be recovered in the event of cancellation.

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