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Expense Recognition

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.

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Expense Recognition

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  1. Expense Recognition Chapter 7

  2. 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

  3. Expense Recognition • Cost, expenditure, and expense • General recognition criteria • Approaches to expense recognition

  4. 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

  5. General Recognition Criteria • Recognized items must: • meet the definition of a financial statement element • have 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

  6. 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

  7. 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

  8. 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?

  9. 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. Selling Costs Materials and Labour

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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 sequencethe costs first incurred should be the first that are matched to revenues.

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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]

  26. 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

  27. Amortization Methods • Amortization (depreciation) alternatives: • straight-line (SL) method • units of production method • declining balance (DB) method • sum-of-the-years'-digits (SYD) method • sinking fund amortization methods

  28. Depreciation Methods Used In Practice • Depreciation methods used in practice • straight-line was used by 90% • declining balance method was used by 21% • units of production was used by 26%. • Why? • Industry practice • Companies are taken with the simplicity of the straight-line method

  29. Depreciation Methods Used In Practice (cont.) • Declining balance methods more common: • for assets that run significant risk of technological obsolescence or • when 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

  30. Deferred Costs • Pre-operating costs • Other deferred charges • Research and development costs • Computer software costs • Website development costs • Exploration and development costs

  31. 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 service • The 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

  32. 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

  33. 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.

  34. 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

  35. 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

  36. Research and Development Costs (cont.) • 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

  37. Research and Development Costs (cont.) • Activities excluded from both research and development: • engineering follow-through in an early phase of commercial production • quality 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

  38. Research and Development Costs (cont.) • 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

  39. Research and Development Costs (cont.) • 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]

  40. 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

  41. 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

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

  43. 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

  44. Exploration and Development Costs (cont.) • The accounting for exploration and development costs varies widely • One extreme is to treat all ED costs as expenses in the period in which they are incurred • The 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

  45. 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

  46. 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)

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