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Let's talk about expense recognition. So we already did a video on revenue recognition, and this is just gonna be its counterpart, expense recognition. We wanna recognize expenses when they're incurred, and this is under accrual. Under cash, we recognize them when they're paid, just like revenue. Cash is all about cash.
The other thing is there's something called the matching principle that we need to look at. So this word incurred stands in opposition to, so incurred is... Well, spelled wrong. Incurred with two Rs. Incurred stands in opposition to paid.
So we want to recognize expenses when they are incurred, not when they're paid. In the same way that we recognize revenue when it's earned, not when the cash is received, we recognize the expense when it's incurred, not when it's paid. And this lines up with the matching principle. And what the matching principle says is that we need to match expenses to the revenues they generate.
And I think the easiest way to look at this one is through the cost of goods sold expense. So let's walk through a whole timeline here. So we buy inventory. We buy inventory, let's just say, in January. We make a sale in February.
Okay? Now, at what point do you think we recognize the expense? Well, you would think it would be right here, right? So let's do the journal entry for this. Buy inventory, we'll just say with cash. So your inventory is gonna go up by 1,000, and your cash is gonna go down by 1,000. And you can see right now there are no expenses because we haven't actually incurred any expenses. We paid cash, but we got an inventory. So right now we're just swapping asset for asset. We're just swapping some cash for some inventory. That's not really an expense. That's just shuffling assets around.
So we haven't really incurred any expenses yet. We also haven't generated any revenues, so there's nothing to match against. So we're not gonna recognize any expense in January because all we did was move some assets around. Now, when we get to February, let's do a journal entry for February.
So in February we make the sale. So let's say we sell it all for 2,000. So we're gonna have cash go up by 2,000, and we're gonna have revenue go up by 2,000. So that's part of the journal entry right there. That's the revenue side. But our inventory also went down, didn't it? 'Cause we sold it. Our inventory went down by 1,000. And now that that inventory has been used up, now that is an expense at that time, and that expense is called cost of goods sold.
So when we sell it is when we actually incur the expense. Up until then, it was just inventory, which is an asset. Once we sell it, then it becomes an expense. And you can see that the expense is matched with the revenue, right? This expense generated that revenue.
This revenue had that expense. So this follows the matching principle that we try to match up expenses and revenues to the same period. So this expense generated this revenue, so we record it at the same time. Because, one, we wanna recognize an expense when it's incurred, not when it's paid. So in the cost of goods sold example, we didn't actually incur an expense until it was gone. We were just swapping around assets. And then we match it with the revenue that it generates. And in this example, the revenue would just be sales revenue, and the expense would be cost of goods sold. Let's take a look at another example.
Let's look at insurance expense. Let's say that we pay $12,000 a year for insurance, and we pay it upfront on January 1. So our cash outlay is gonna look like this, $12,000 cash paid. But we know that the paying of cash does not necessarily mean it's an expense, right? In this case, again, we're just swapping around assets. We're going to increase our prepaid insurance 12,000, and we're just gonna decrease cash 12,000. We're gonna do this on January 1. Because on January 1, right here, we haven't incurred any expenses at all. We haven't incurred the cost of being insured for a month.
Right? So as we go on throughout the year, we incur costs of being insured. So on February 1, we have incurred now a month's worth of being insured, right? The company insured us all through January, and that's done. That's in the past. We incurred that expense, but we didn't pay any more for it, so what do we do? We just say insurance expense for the month of January, one month, and we don't touch cash again because we're not paying more. We're just taking down our prepaid. So we decrease our prepaid by 1,000. And actually, you're probably gonna do this at the end of the first month, not the beginning of the second.
So let's call that 1/31, because you're gonna need to do it at the end of the year on 12/31. So as the months go on, you're incurring $1,000 of expense each month until at the end of the year, you've used it all up. This prepaid insurance will be zero, and the total of your insurance expense will be $12,000. And so what we're doing here is we're trying to match the expense that we paid into the period where it generated a benefit for us. In January, we had the benefit of having insurance. And so once January is over, we wanna record the expense that generated that benefit for us.
We're gonna talk more about these prepaid assets and prepaid liabilities in a different video. But for now, the important thing to remember is that you recognize expenses when they are incurred, and then you try to match the expense to the revenue or to the period that the expense generated the benefit in.