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. - PowerPoint PPT Presentation
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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
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
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?
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
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 (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.
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
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
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
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]
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
straight-line (SL) method units of production methoddeclining balance (DB) methodsum-of-the-years'-digits (SYD) methodsinking fund amortization methods
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
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
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]
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
(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
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
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)