The IASB Conceptual Framework describes expenses as “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.”
General Principles of Expense Recognition
A company recognizes expenses in the period that it consumes the economic benefits associated with the expenditure, or loses some previously recognized economic benefit.
Under the matching principle, a company recognizes some expenses (for example, cost of goods sold) whenever the associated revenues are recognized, thereby matching expenses and revenues. Matching requires that a company recognizes the cost of goods sold in the same period as revenues from the sale of the goods.
Period costs are expenditures that less directly match revenue, and are reflected in the period when a company has the expenditure or incurs a liability.
Matching applied to inventory and cost of goods sold
Under the specific identification method, the inventory and cost of goods sold are based on their physical flow. IFRS and US GAAP, however, permit the use of the first in, first out (FIFO) method, and the weighted average cost method to assign costs.
The FIFO method assumes that the oldest goods that are purchased or manufactured are sold first while the newest goods purchased or manufactured remain in inventory. The cost of goods in the beginning inventory and the costs of the first items purchased or manufactured flow into the cost of goods sold first, implying that the items that were purchased first are sold first. As a result, the ending inventory would include the most recent purchases.
Under the weighted average cost method, the average costs of goods available for sale are assigned to the units sold and the units remaining in inventory.
The last in, first out (LIFO) method is another method that can be used to assign costs under US GAAP, but not under IFRS. Under LIFO, the newest goods that are purchased or manufactured are assumed to be sold first while the oldest goods purchased or manufactured are assumed to remain in inventory. As a result, the costs of the newest items purchased will flow into the costs of goods sold first, as if the most recent items that were purchased, were sold first.
Specific Expense Recognition Applications
Doubtful accounts: Using the matching principle, once revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. This estimate is recorded as an expense on the income statement, not as a direct reduction of revenue.
Warranties: Using the matching principle, companies are required to estimate the amount of future expenses which result from warranties, to recognize estimated warranty expenses in the periods of sale, and to update the expenses as indicated by experience over the life of the warranties.
Depreciation and Amortization: Depreciation describes the process of systematically allocating the costs of long-lived assets over the period during which these long-lived assets are expected to provide any economic benefits. The term amortization is used whenever the long-lived assets are intangible and have a finite, useful life. There are several methods for computing depreciation. These include the straight-line method, diminishing balance method (declining balance method), and the units of production method.
- Under the straight-line method, the cost of long-lived assets less the estimated residual value is allocated evenly over the estimated useful life of the asset.
- The diminishing balance and the units of production methods are referred to as accelerated methods of depreciation because they accelerate the timing of depreciation by allocating a greater proportion of the depreciation expense to the early years of an asset’s useful life. There is, therefore, a higher depreciation expense in the earlier years relative to the straight-line method. As a result, there are higher expenses and lower net income in the early depreciation years.
Implications of Expense Recognition Choices for Financial Analysis
The choice of depreciation or amortization method, as well as the estimate of useful life and residual value, can affect a company’s reported net income. So too does the estimates that the company uses for doubtful accounts and warranty expenses.
Knowledge of the monetary effect of differences in expense recognition policies and estimates can facilitate more meaningful comparisons across a number of companies or within a single company’s historical performance. This monetary effect may be used to adjust the reported expenses so that they are more comparable. If however the monetary effects of differences in policies and estimates cannot be computed, it is also possible to characterize the relative conservatism of the policies and estimates and to qualitatively assess how such differences might affect reported expenses and financial ratios.
If the cost of an asset is $100,000, and its residual value is estimated to be $10,000, while its useful life is estimated to be 6 years, what is the annual depreciation expense under the straight-line method?
The correct answer is B.
Annual depreciation expense = ($100,000 – $10,000)/6 years = $15,000.
Reading 21 LOS 21d:
Describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis