GODFREY HODGSON HOLMES TARCA CHAPTER 10 EXPENSES Expenses

GODFREY HODGSON HOLMES TARCA CHAPTER 10 EXPENSES

Expenses defined • Expenses are 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 • (Framework para. 70) 2

Expenses defined • The decrease in value pertains eventually to the outflow of cash • Expenses encompass losses as well as expenses which arise in the course of ordinary activities • The distinction between abnormal and extraordinary items is no longer permitted 3

Expenses defined • To make a definition of expenses operational, it must be associated with a physical activity of the entity - something it does – production and sales generate revenue and the using up of goods and services in support of those functions causes expenses to occur 4

Changes in assets and liabilities • Expenses represent a value change • Framework definition of expenses refers to outflows or depletions of assets or incurrence of liabilities • Framework makes no reference to the relationship of expenses to revenue 5

Expenses and ‘costs’ • Sometimes an expense is referred to as an ‘expired cost’ • The using up of assets entails a cost - expense - to the entity • If there is no cost to the firm there is no expense 6

Expense recognition • The recognition criteria for expenses are consistent with those of the other accounting elements 7

Expense recognition • An expense is recognised if – it is probable that any future economic benefit associated with the item will flow to or from the entity; and – the item has a cost or value that can be measured with reliability • prudence and neutrality • freedom from material error and bias, represent faithfully 8

Expense recognition • The decrease in future economic benefits relates to a decrease in an asset or an increase in a liability – recognition of an expense occurs simultaneously with the recognition of an increase in a liability or a decrease in assets 9

Expense measurement • In measuring expenses a number of decisions have to be made as to how expenses should be allocated over periods of resultant revenue – accrual accounting – matching expenses against revenues in the period to which they relate 10

Allocation of expenses • Revenue = accomplishment • Expenses = effort • For any given period, matching revenue and expenses yields net accomplishment (periodic profit) • Most of the problems of profit determination have to do with expense allocation and matching 11

Allocation of expenses • The accountant must decide – whether a cost pertains to future revenues and therefore should be deferred – whether a cost pertains to current revenues and therefore should be written-off against that revenue in the current period – whether a cost, although incurred and not yet paid, is related to current revenue and therefore should be accrued 12

Allocation of expenses • The matching process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events – sales and cost of goods sold 13

Allocation of expenses • In practice, matching is – very difficult to do – involves a great deal of judgement – arbitrary 14

Allocation of expenses • Three basic methods of matching – associating cause and effect – systematic and rational allocation – immediate recognition 15

Associating cause and effect • The ideal way of matching is by associating cause with effect • Cause and effect relationships are very difficult to prove – reasonable observation 16

Systematic and rational allocation • An alternative is to use a systematic and rational allocation procedure – associate expenses to segments of time – the expense is assumed to correlate with the revenue for that period • depreciation • Requires estimates and assumptions which are usually arbitrary 17

Immediate recognition • Used if neither of the previous two can be used • Recognise the outlay immediately as an expense – advertising expenses – research expenditure – impairment expenses 18

Criticisms of allocations • The doctrine of conservatism means that expenses, losses and liabilities are recognised as soon possible, even if evidence for them is weak • The asymmetrical treatment of revenue and expenses may create a conservative bias and misleading financial statements • Personal incentives may influence managers’ judgement in the allocations process 19

Criticisms of allocations • The allocations (matching) process is an essential part of accounting practice • The process has made the balance sheet secondary to the income statement • The balance sheet has become a repository for unexpired costs • Most of what accountants put in accounting reports is ‘rubbish’ 20

Criticisms of allocations • The allocation problem – Thomas – allocations in accounting do not meet the following criteria • additivity • unambiguity • defensibility 21

Criticisms of allocations • Allocations are defended by accountants on two grounds – a given input provides services in the current and future periods and the cost allocation pattern reflects the cost of the services received in the given periods – allocated data serves a useful purpose because readers of accounting reports, which include allocated data, find them useful 22

Criticisms of allocations • But, allocations are ‘incorrigible’ - Thomas – they are not capable of verification or refutation by objective, empirical means – the patterns of allocation do not exist in the realworld; they exist only in the minds of accountants – an input’s individual contribution to the output cannot be known because all the inputs interact with each other to generate an output – empirical studies do not demonstrate that allocations are useful 23

Criticisms of allocations • Alternative approaches suggested – exit price accounting • no allocations 24

Defence of allocations • Change the objective of allocations • Continue with allocations only if the benefits outweigh the costs of doing so 25

Challenges for accounting standard setters • The IASB is aware of the allocations problem and is tackling it in its current projects • The plea is for reasonableness or appropriateness and not for objective evidence – contradicts the recognition of revenue – conservatism 26

Issues for auditors • Auditors face issues surrounding the distinction between expenses and assets, the period in which expenses are recognised, and appropriate measurement of expenses – big bath and cookie jar accounting – concepts such as matching and conservatism are not helpful if they distort information and reduce its utility – managers have incentives to distort expenses 27

Summary • The nature of expenses and the way they are defined • Recognition criteria and the matching concept as they are applied to expenses in the accrual accounting system • Criticisms of the matching process and accountants’ use of allocations • Challenges for standard setters • Issues for auditors 28

Key terms and concepts • • • • Expenses Definitions Economic benefits Recognition criteria Probable and reliable Expense measurement Matching Allocation of expenses Associating cause and effect Systematic and rational allocation Immediate recognition Criticisms of allocations Conservatism 29

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