Expense Recognition

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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Michael L. Hockenstein Commerce Department • Vanier College

Intermediate Accounting

Thomas H. BeechySchulich School of Business, York University

Joan E. D. ConrodFaculty of Management

Dalhousie University

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-2

Expense Recognition

Chapter 7


Introduction

Policies must be chosen to recognize expenses

There are areas where generally accepted accounting principles allow significant latitude

Accountants and financial statement users have to be on their toes in this area


Expense Recognition

Cost, expenditure, and expense General recognition criteria Approaches to expense recognition


Cost, Expenditure, and Expense

When we agree to pay out cash (or other assets) for goods or services received, we have incurred a cost

When we actually pay the cash, we have an expenditure

When the benefits of the cost have been used and we put that cost (or a portion thereof) on the income statement, we have recognized an expense


General Recognition Criteria Recognized items must:

meet the definition of a financial statement elementhave a valid measurement basis and amount

Financial statement elements are based on future economic benefits or sacrifices; these must be probable for recognition to be appropriate


General Recognition Criteria(cont)

Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from an entity’s ordinary revenue generating or service delivery activities [CICA 1000.38]

Asset or expense? if the asset recognition criteria are met, an asset is recorded. If not, an expense is recorded


Approaches to Expense Recognition

Definitional approach: expenses are created either through the reduction of an asset or the increase in a liability

Matching approach: once revenues are determined in conformity with the revenue principle for any reporting period, the expenses incurred in generating the revenue should be recognized in that period


Measurement

Recognition is not possible unless there is a reliable amount to record

If the expense has to be accrued at the revenue recognition point, prior to settlement, accurate measurement of the liability, and, by inference, the expense, is a major concern

Another major issue in expense measurement deals with the issue of interperiod allocation: what amortization policies are appropriate?


Expense Categories

Direct expenses: expenses that are associated directly with revenues, e.g., cost of goods sold

These expenses are recognized at the same time as the related revenues. They can also be called product costs or project costs.


Expense Categories (cont.)

Indirect costs: expenditures which are not associated directly with revenues, e.g., interest costs and administrative salaries

These are often called period costs


Specific Expense Policies Two specific expenses:

cost of goods sold amortization

These are important areas: they represent significant expense categories

on many income statements there are potentially material differences in

expense patterns associated with different policies


Cost of Goods Sold

Management must choose a cost allocation procedure for allocating the total cost of goods available for sale during each period between (1) the cost of goods sold (2) the cost of the ending inventory

Inventory accounting policy determines the flow of costs through the accounting system, not the flow of goods physically in and out of a stockroom


Underlying Concepts of Cost Flow

Specific cost identification Average cost First-in, first-out Last-in, first-out Comparison of methods Other issues in inventory

costing


Specific Cost Identification

Each item stocked must be specifically marked so that its unit cost can be identified at any time

Automotive dealers use the specific cost method for two reasons: First, the dealer’s specific cost is an important

determinant of the sales price Second, each car is unique, and

the serial number links it to a specific invoice cost


Average Cost

The average cost method assumes that the cost of inventory on hand at the end of a period and the cost of goods sold during a period is representative of all costs incurred during the period

(Inventory cost + current purchase cost)Total units on hand

The moving-average method is generally viewed as objective, consistent, and not subject to easy manipulation


First-in, First-out

The first-in, first-out method (FIFO) treats the first goods purchased or manufactured as the first units expensed out on sale or issuance

Goods sold (or issued) are valued at the oldest unit costs, and goods remaining in inventory are valued at the most recent unit cost amounts


First-in, First-out (cont.) There are two common rationalizations for the use of

FIFO:FIFO approximates the physical flow of

merchandise and materials–generally speaking, items that are purchased first are sold first or used first in operations

Under historical cost accounting, costs should be matched to revenue in historical sequencethe costs first incurred should be the first that are matched to revenues.


Last-in, First-out

The last-in, first-out method (LIFO) of inventory costing charges the cost of the most recently acquired items to cost of goods sold

The units remaining in ending inventory are costed at the oldest unit costs incurred, and the units included in cost of goods sold are costed at the newest unit costs incurred, the exact opposite of the FIFO cost assumption


Comparison of Methods

The impact that the inventory cost flow assumption has on the financial statements depends on whether prices are going up or down

In periods of rising prices, FIFO results in higher inventory balances, lower cost of goods sold, and higher profits

LIFO has the opposite effect: lower inventories and lower profits

Canada Customs and Revenue Agency does not allow firms to use LIFO for tax purposes


Comparison of Methods (cont.)

Average cost is always in the middle between FIFO and LIFO---the middle inventory value, and the middle cost of goods sold figure

Average cost is allowed for tax purposes, and is likely to result in a lower taxable income than FIFO if prices are rising


Other Issues In Inventory Costing There is an important issue of determining which

costs to include in inventory and which to treat as period costs

There is a great deal of flexibility in the matter, and it is not unusual for a company to use three different definitions of inventoriable cost: one for internal decision-making

(management accounting), one for income tax purposes, and one for external financial reporting


Asset Amortization

When an expenditure is made, it becomes either an expense (no future benefit that meets the recognition criteria) or an asset (recognition criteria are met)

Assets do not remain on the balance sheet forever, except for land


Asset Amortization (cont.)

Some assets are expensed in their entirety at the revenue recognition point---inventory is the best example of this

Some are expensed as they are consumed in the earnings process---supplies

Others are used or consumed in the earnings process over a period of time, and must be amortized, or expensed, gradually


Asset Amortization (cont.)

Amortization: the periodic allocation of the cost of capital assets over the useful life of the assets

Depreciation: amortization of tangible capital assets, e.g., buildings, furniture, and equipment

Depletion: amortization of natural resources


Nature of Amortization In referring to capital assets, the CICA Handbook

states that:Amortization should be recognized in a

rational and systematic manner appropriate to the nature of the capital asset. [CICA 3060.31]

In the section on research and development costs, the CICA Handbook states that amortization:

should be charged as an expense on a systematic and rational basis by reference, where possible, to the sale or use of the product or process. [CICA 3450.28]


Nature of Amortization (cont.)

Amortization expense is not recognized for sudden and unexpected factors, such as damage from natural phenomena, sudden changes in demand, or radical misuse of assets that impair their revenue-generating ability


Amortization Methods

Amortization (depreciation) alternatives:

straight-line (SL) method units of production methoddeclining balance (DB) methodsum-of-the-years'-digits (SYD) methodsinking fund amortization methods


Depreciation Methods Used In Practice

Depreciation methods used in practicestraight-line was used by 90%declining balance method was used by 21% units of production was used by 26%.

Why? Industry practiceCompanies are taken with the simplicity of the

straight-line method


Depreciation Methods Used In Practice (cont.)

Declining balance methods more common: for assets that run significant risk of technological

obsolescence orwhen repair costs are expected to mount up later

in an asset’s life when they must use a form of declining balance

for many assets for tax reporting

Units of production is used in the resource industry


Deferred Costs

Pre-operating costs Other deferred charges Research and development costs Computer software costs Website development costs Exploration and development costs


Pre-operating Costs The CICA’s Emerging Issues Committee suggested

that an established company can defer (and amortize) expenditures in the pre-operating period to the extent that:The expenditure is related directly to placing the

new business into serviceThe expenditure is incremental in nature

(i.e., a cost that would not have been incurred in the absence of the new business)

It is probable that the expenditure is recoverable from the future operation of the new business


Pre-operating Costs (cont.)

Once in commercial operation, the pre-operating expenditures should be amortized

The EIC indicated that this amortization period should not normally exceed five years


Other Deferred Charges

Section 3070 of the CICA Handbook deals with the disclosure of deferred charges, but recognition concerns are not discussed

Long-term deferred charges are excluded from current assets and reported either as a separate category or under Other Assets on the balance sheet.


Research and Development Costs

Research: planned investigation undertaken with the hope of gaining new scientific or technical knowledge and understanding

Development: the translation of research findings or other knowledge into a plan or design for new or substantially improved materials, devices, products, processes, systems, or services prior to the commencement of commercial productions or use


Research and Development Costs (cont.)

Activities included in research:

Laboratory research aimed at discovery of new knowledge

Searching for applications of new research findings or other knowledge

Conceptual formulation and design of possible product or process alternatives



Activities included in development:

testing in search for, or evaluation of, product or process alternatives

design, construction, and testing of pre-production prototypes and models

design of tools, jigs, molds, and dies involving new technology


Research and Development Costs (cont.) Activities excluded from both research and

development:engineering follow-through in an early phase of

commercial productionquality control during commercial production,

including routine testing of products troubleshooting in connection with breakdowns

during commercial production routine or periodic alterations to existing products,

production lines, manufacturing processes, and other ongoing operations, even though such alterations may represent improvements



Section 3450 of the CICA Handbook recommends that research costs should be charged to expense when incurred

Development costs may be capitalized and amortized if all of the following criteria are met: the product or process is clearly defined and the costs

attributable thereto can be identified the technical feasibility of the product or process has been

established



the management of the enterprise has indicated its intention to produce and market, or use, the product or process

the future market for the product or process is clearly defined or, if it is to be used internally rather than sold, its usefulness to the enterprise has been established

adequate resources exist, or are expected to be available, to complete the project. [CICA 3450.21]


Computer Software Costs

Accounting issues concerning the costs of developing computer software arise in two different contexts:

(1) Companies develop computer software systems for their internal use, either by developing the software with their own staff or by contracting with an outside developer

Note: Apply the AcSB’s criteria as outlined in the previous section


Computer Software Costs (cont.)

(2) Companies develop software as a product to be sold to outsiders

Under the FASB standard, software development costs are expensed as incurred until all the planning, designing, coding, and testing activities necessary to establish that the product can be produced to meet its design specifications are completed, or until a working model of the software is completed

Subsequent costs for further coding, testing, debugging, and producing masters of the software product to be duplicated in producing saleable products are capitalized


Website Development Costs

Website development costs are generally expensed unless there is a long-term benefit , in which case capitalization and amortization is appropriate


Exploration and Development Costs

Exploration and development (ED) costs are the costs that oil and gas companies and mining companies incur in exploring and developing their resource properties

Exploration: the process of seeking mineral deposits

Development: the process of turning a found deposit

into a productive mine site or oil field


Exploration and Development Costs (cont.) The accounting for exploration and development costs

varies widelyOne extreme is to treat all ED costs as expenses in

the period in which they are incurredThe more common approach is to defer and

amortize those costs The value of the intangible asset is not the value of the

mineral resources; it is only the cost of getting at them Depletion is usually calculated on a unit-of-production

basis, using the estimated reserves as the denominator in the per-unit calculation


Enterprises in the Development Stage

Enterprises in the development stage have not begun principal operations

Costs are accounted for by their nature, but are often classified as development costs and are eligible for deferral if the deferral criteria are met


Cash Flow Reporting Of Capitalized Costs

Costs that are accounted for as expenses are included in the cash flow from operations

Costs that are accounted for as assets are included in the investing activities section of the cash flow statement

Amortization on capitalized assets is deducted in determining net income, but is removed from cash flow from operations (either by adding it back in the indirect approach, or leaving it out in the direct approach)

Documents

Expense Recognition