Introduction The purpose of this paper is to explain the Revenue recognition principle and Expense recognition principle The paper will describe the four situations that require adjusting journal entries and provide one example for prepaid expenses unearned revenues Accrued expenses Accrued revenues Revenue recognition principle The revenue recognition principle along with the matching principle is an important principle in accrual accounting It states that revenue should be reported when it is earned or in cash accounting when the cash payment is made This helps to determine the accounting period or the period of time in which revenue and expenses must be recorded General rules in the revenue recognition principle are that revenues are reported as soon as the goods or services being offered in exchange for payment have been completed In some cases they will be reported once the payment has been received and cleared but this is not always the case Cash received that has not been earned yet is not recorded as revenue but as a liability This means that this money is not recorded as a cash payment until the services being offered have been provided to the customer There are four types of revenue which must be recorded as stated in the revenue recognition principle The first is cash payments given in exchange for goods This would be recorded on either the date the sale is made or the date of delivery The second is revenues earned from doing services for a client and they are recorded when those services are complete and billed Revenues from borrowing the company s assets or money earned from selling company assets must also be recorded Exceptions to the revenue recognition principle include inventory sold with a buyback agreement or with a return policy in place In either case the transaction cannot be complete until the buyback or return period has passed since there is no way to determine which a return will be made on an item Long term contracts are another exception as they take time to complete even when cash is paid in advance Sometimes money will be paid and recorded as various intervals during a large project other times the transaction is recorded once the work is complete In some cases the revenue recognition principle states that revenues must be recorded even before any sale has been made In agriculture for instance revenues must be recorded at harvest time because there is a constant market for food items the prices are fairly stable and assured and distributing goods does not cost much These stipulations must be present in order for revenues to be counted before an actual sale Expense recognition principle Expenses are commonly distinguished from losses for three reasons Expenses result from an entity s central operations losses result from incidental or peripheral activities of the entity Expenses are often incurred during the earnings process losses often result from nonreciprocal transactions such as thefts or fines or other economic events unrelated to an earnings process Expenses are reported gross losses are reported net To determine the income related to a company s primary operations during the accounting period the expenses efforts are recognized and matched against the revenues benefits There are three expense recognition principles to properly match expenses against revenues 1 Association of Cause and Effect Some costs are recognized as expenses on the basis of a presumed direct association with specific revenues 2 Systematic and Rational Allocation Some costs are recognized as expenses in a particular accounting period based on a systematic and rational allocation among the periods in which benefits are provided 3 Immediate Recognition Some costs are recognized as expenses in the current accounting period because 1 the costs incurred during the period provide no discernible future benefits i e they do not result in assets or 2 the allocation of costs among accounting periods or because of cause and effect relationships is not useful Although many cash outflows are recognized directly as expenses this accounting is often done for expediency since most expenses are first assets if only for a brief moment Measuring the consumption of assets is done by one of three pervasive measurement principles associating cause and effect systematic and rational allocation or immediate recognition Some costs such as materials and direct labor consumed in the manufacturing process are relatively easy to identify with the related revenue elements The matching principle requires that all expenses incurred in the generation of revenue should be recognized in the same accounting period as the related revenues are recognized Thus those cost elements are included in inventory and expensed as cost of sales when a product is sold and revenue from the sale is recognized That process is associating cause and effect Other costs are more closely associated with specific accounting periods In the absence of a cause and effect relationship the asset s cost should be allocated to the accounting periods benefited in a systematic and rational manner This form of expense recognition involves assumptions about the expected length of benefit and the relationship between benefit and cost of each period Depreciation of plant property and equipment amortization of intangibles and allocation of rent and insurance are examples of costs that are recognized by the use of a systematic and rational method Expenses do not include distributions withdrawals or dividends to owners Expenses of a corporation are easily identified and separated from distributions to stockholders In both the sole proprietorship and partnership form of entity the identification process can be more difficult Items such as interest or salaries paid to partners or owners may be thought of as distributions of profits rather than expenses Adjusting journal entries are made at the end of each closing period to adjust the account balances Most times this is necessary in order to achieve a clean cut off at the end of the accounting period and to ensure the accounts are complete and accurate Current account balances may not represent correct balances because mistakes were identified in the posting of transactions and or the accounting records are not updated to reflect new transactions or amount changes in previous transactions Examples would include amounts posted to the wrong accounts and timing differences in recognizing revenues and