Principles of Expense Recognition

The IASB Conceptual Framework defines expenses as reductions in economic benefits occurring throughout the accounting period. These reductions manifest as outflows or depletions of assets or the incurrence of liabilities, leading to a decrease in equity. Notably, this excludes reductions related to distributions to equity participants.

General Principles of Expense Recognition

Typically, a company records expenses when it uses up the economic benefits related to the expenditure or when it forfeits a previously recognized economic benefit. There are three prevalent models for recognizing expenses: the matching principle, immediate expensing upon incurring, and capitalization followed by gradual depreciation or amortization.

Matching Principle Model

In the matching approach, a company records expenses, such as the cost of goods sold, when the related revenues are recognized, thereby aligning expenses and revenues. These associated revenues and expenses arise directly and jointly from the same transactions or events.

Unlike a simple situation where a company buys inventory and sells all of it within the same accounting period, it is more common for some sales in the current period to come from inventory purchased in a previous period or periods. Similarly, it is likely that some inventory bought in the current period will remain unsold at the end of the period and will be sold in a subsequent period.

The matching approach requires that a company recognize the cost of goods sold in the same period as the revenues from the sale of those goods. It is important to note that IFRS does not explicitly refer to a “matching principle” but rather to a “matching concept” or a process that results in the “matching of costs with revenues.

Example: Applying Matching Principle

Anderson Merchandising Corporation (AMC), a hypothetical company, acquires inventory items to resell them. At the start of 20X2, AMC had no inventory in stock. Throughout 20X2, AMC engaged in the following transactions:

$$\begin{align} &\textbf{Inventory Purchases}\\ &\begin{array}{l|r|r} \textbf{Quarter} & \textbf{Units} & \textbf{Cost per Unit} \\ \hline \text{First quarter} & 2,500 & \text{USD38} \\ \text{Second quarter} & 1,800 & \text{USD39} \\ \text{Third quarter} & 2,000 & \text{USD42} \\ \text{Fourth quarter} & 2,300 & \text{USD44} \\ \hline \textbf{Total} & 8,600 & \textbf{USD163} \\ \end{array} \end{align}$$

During the year, AMC sold 6,500 inventory units at USD48 per unit, receiving payment in cash. AMC established that 2,100 units of inventory were left over, with 2,000 units specifically identified as being bought in the fourth quarter and 100 units acquired in the third quarter.

Determine the revenue and expenses related to these transactions in 20X2 by identifying the specific inventory items sold or remaining in stock, assuming the company anticipates no product returns.

Solution:

The income for 20X2 would amount to USD312,000, calculated from the sale of 6,500 units at USD48 each. Initially, the overall cost of the acquired goods, totaling USD351,400, would be recorded as inventory (an asset). Throughout 20X2, the expense for the 6,500 units sold would be deducted (aligned with the revenue). In contrast, the expense for the remaining 2,100 units that were not sold would continue to be listed as inventory, as detailed below:

$$\begin{align}
&\textbf{Cost of Goods Sold}\\
&\begin{array}{l|l}
\text{Source} & \text{Amount} \\
\hline
\text{From the first quarter} & 2,500 \text{ units at USD38 per unit} = \text{USD95,000} \\
\text{From the second quarter} & 1,800 \text{ units at USD39 per unit} = \text{USD70,200} \\
\text{From the third quarter} & 2,000 \text{ units at USD42 per unit} = \text{USD84,000} \\
\hline
\textbf{Total cost of goods sold} & \textbf{USD249,200} \\
\end{array}
\end{align}$$

$$\begin{align}
&\text{Cost of Goods Remaining in Inventory}\\
&\begin{array}{l|l}
\textbf{Source} & \textbf{Amount} \\
\hline
\text{From the third quarter} & 100 \text{ units at USD42 per unit} = \text{USD4,200} \\
\text{From the fourth quarter} & 2,000 \text{ units at USD44 per unit} = \text{USD88,000} \\
\hline
\textbf{Total remaining}&\\
\text{(or ending) inventory cost} & \textbf{USD92,200} \\
\end{array}
\end{align}$$

The cost of the goods sold would be expensed against the revenue of USD312,000 is shown below:

$$ \begin{array}{l|r}
\textbf{Item} & \textbf{Amount} \\ \hline
\text{Revenue} & \text{USD312,000} \\ \hline
\text{Cost of Goods Sold} & \text{USD249,200} \\ \hline
\textbf{Gross Profit} & \textbf{USD62,800} \\
\end{array}$$

Immediate Expensing upon Incurring

Period costs (expenses less directly linked to revenue generation) are typically expensed as incurred, either when the company pays out cash or incurs a liability. These costs often include administrative, managerial, information technology (IT), research, and development expenses, as well as costs for maintaining or repairing assets.

For most companies, payroll expenses are treated as period costs, except for employees whose compensation is regarded as a product cost and recorded as inventory, subsequently becoming part of the cost of goods sold, or expenses like sales commissions, which are capitalized and systematically expensed or expensed alongside sales.

Capitalization followed by Gradual Depreciation or Amortization

Certain expenditures are initially recognized as assets on the balance sheet and typically manifest as an investing cash outflow on the statement of cash flows. Over the asset’s useful life, these capitalized amounts are expensed as depreciation or amortization, reducing both net income and the asset’s value on the balance sheet. As non-cash expenses, depreciation, and amortization impact the cash flow statement primarily through their effect on taxable income and taxes payable.

This approach aligns with the matching principle, where expenses are recognized on the income statement over the asset’s expected useful life, ensuring that costs and benefits are matched. Capitalizing expenditures, instead of expensing them, generally results in higher reported cash from operations. Analysts should be vigilant for signs of companies manipulating reported cash flow from operations by capitalizing expenditures that ought to be expensed.

Capitalizing an expenditure boosts current profitability and reported cash flow from operations as long as capital expenditures exceed depreciation expenses. When analyzing performance, it’s essential to consider the motivations behind capitalizing expenditures, such as meeting earnings targets for a specific period. Conversely, expensing a cost in the current period lowers immediate profits but enhances future profitability, contributing to a positive profit trend.

In environments where financial reporting and tax accounting methods are identical, expensing has a more favorable impact on cash flow due to lower taxes in the earlier period, creating an opportunity for interest income on the saved cash.

While it may not be feasible to identify individual instances of discretion in capitalizing or expensing expenditures, analysts can typically identify significant items treated differently across companies. The most relevant differences in expenditure treatment will vary by industry, highlighting the importance of industry-specific considerations in the analysis of capitalization practices.

Capitalization of Interest Costs

Companies typically capitalize interest costs for assets that require an extended period to prepare for their intended use. This accounting practice allows interest costs to be either capitalized on the balance sheet or expensed on the income statement. For assets constructed for the company’s use, capitalized interest is included as part of the relevant long-lived asset on the balance sheet and is expensed over time through depreciation. In contrast, for assets constructed for sale, such as in the case of a real estate construction company, capitalized interest is included in the inventory and expensed as part of the cost of sales when the asset is sold.

The treatment of capitalized interest raises several considerations for analysts. Firstly, it affects the categorization of cash flow, with capitalized interest appearing as part of investing cash outflows, while expensed interest typically reduces operating cash flow. Under US GAAP, interest is categorized in operating cash flow, whereas under IFRS, it can be categorized in operating, investing, or financing cash flows. Analysts may need to assess the impact on reported cash flows. Secondly, interest coverage ratios, which are indicators of solvency, measure the extent to which a company’s earnings or cash flow cover its interest costs. Capitalized and expensed portions of interest expenditure should be considered in the calculations to assess a company’s interest coverage. Additionally, if a company is depreciating interest capitalized in a previous period, income should be adjusted to eliminate the effect of that depreciation.

Overall, understanding the treatment of capitalized and expensed interest is crucial for accurately assessing a company’s cash flows and solvency, particularly when analyzing interest coverage ratios and assessing compliance with covenant requirements in lending agreements.

Capitalization of Internal Development Costs

Accounting standards mandate capitalizing software development costs upon establishing product feasibility. However, variations arise due to judgment in feasibility assessment, leading to differing capitalization practices. Choosing to expense development costs instead of capitalizing them reduces current-period net income. This holds as long as current development expenses surpass amortization from prior capitalized costs, typical during cost escalation.

Opting for expense recognition for development costs lowers net operating cash flows and elevates net investing cash flows on the cash flow statement. Adjustments can align their financial performance when comparing companies like Microsoft (expenses development) to those capitalizing. Adjustments include (1) recognizing software development costs as expenses in the income statement, excluding prior years’ amortization; (2) deducting capitalized software from the balance sheet (reducing assets and equity); and (3) reducing operating cash flows and cash used in investing on the cash flow statement by current-period development costs. Ratios involving income, assets, and cash flow–like return on equity–will also be influenced.

Implications for Financial Analysts: Expense Recognition

Similar to revenue recognition, a company’s choice of expense recognition reflects its conservatism. Policies deferring expense recognition are less conservative. Expense items often require estimations impacting net income significantly. Analyzing financial statements and comparing companies necessitates understanding estimation variations and their potential influence.

For instance, substantial changes year-to-year in estimates like uncollectible accounts, warranty expenses, or asset valuable lives need scrutiny. Are changes due to operational shifts or manipulation for net income impact? When different industry companies exhibit contrasting estimates, the reasons behind the differences should be explored. Do these differences align with operational variations or signal manipulation?

Companies detail accounting policies and key estimates in financial statement notes and annual reports. Where possible, quantifying policy and estimation differences aid meaningful comparisons, adjusting reported expenses for comparability. If precise effects can’t be calculated, assessing the relative conservatism qualitatively helps understand the impact on expenses and financial ratios.

Example: Effect of Capitalizing versus Expensing

Companies A and B have identical beginning-of-the-year book equity values and share the same tax rate. Throughout the year, both companies engage in similar transactions and report them in the same manner, with one exception. On 1 January of the new year, each company purchases a piece of machinery valued at EUR 500,000, which has a useful life of five years and a salvage value of EUR 0. Company A opts to capitalize the machinery and depreciate it using the straight-line method, while Company B chooses to expense the machinery immediately. The year-end data for Company A is presented in the table below.

Company A as of 31 December

$$\begin{array}{|l|l|} \hline \text{Item} & \text{Value} \\ \hline \text{Ending Shareholders’ Equity} & \text{EUR 15,000,000} \\ \text{Tax Rate} & \text{25\%} \\ \text{Dividends} & \text{EUR 0.00} \\ \text{Net Income} & \text{EUR 1,200,000} \\ \hline \end{array}$$

Based on the information in the table above, Company B’s return on equity using year-end equity will be closest to:

Solution

Company B will have an additional EUR 400,000 of expenses (as of 31 December) compared with Company A. Company B expensed the machinery for EUR 500,000 rather than capitalizing the machinery and having a depreciation expense of EUR 100,000 like Company A. Company B’s net income and shareholders’ equity will be EUR 300,000 lower (= EUR 400,000 × 0.75) than that of Company A. As such, company B’s ROE

$$\begin{align}\text{ROE} = \frac{\text{Net income}}{\text{Shareholders’ Equity}} = \frac{\text{EUR} 900,000}{\text{EUR} 14,700,000} = 0.0612 = 6.12\%\end{align}$$

Question

Why is understanding the treatment of capitalized interest important when analyzing financial statements?

1. It affects the balance sheet items only.
2. It has no impact on cash flow categorization.
3. It influences both cash flow categorization and interest coverage ratios.

Solution

The correct answer is C

The treatment of capitalized interest impacts how interest costs are categorized in the cash flow statement and affect the calculation of interest coverage ratios. Both aspects are crucial in assessing a companys’ financial health and solvency.

A is incorrect. The treatment of capitalized interest also affects the income statement and cash flow statement. While it does impact the balance sheet by increasing the carrying amount of the asset to which the interest is capitalized, it also affects the income statement by reducing interest expense in the period the interest is capitalized. This, in turn, affects the calculation of interest coverage ratios.

B is incorrect. Capitalized interest does impact cash flow categorization. In the cash flow statement, interest paid is typically classified as an operating activity. However, when interest is capitalized, it is included in the investing section as part of the cash outflow for the acquisition of the asset. This reclassification affects the presentation of cash flows and can influence the analysis of a company’s operating performance and investment activities.