Accounting for Expenses

8/10/2019 Accounting for Expenses

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Accounting for Expenses

Author Martin, Jim

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Abstract Next to revenue recognition, accounting for expenses gives accountants more headaches than any

other type of transaction. In 2000, the Public Oversight Board's Panel on Audit Effectiveness Report and

Recommendations found that, among the seven most frequently misstated transactions and accounts,

expenses ranked second behind revenue. Several years ago, this author analyzed common pitfalls in the

revenue area. The author has now analyzed recent SEC Accounting and Auditing Enforcement Releases

(AAER) that deal with expense misstatements. A search of the SEC's database of AAERs issued during the

2000-2007 period identified approximately 185 releases containing instances of expense misstatement.

Auditors can and must improve their ability to detect material misstatements in financial statements. Auditors

must be cognizant of the methods of misstatement, and design their audit programs accordingly. The AICPA's

Audit Risk Alerts are useful in spotlighting potential problems, but the AICPA should consider issuing an SAS

that focuses on expense-transaction auditing problems.

Full text Headnote

A Risk-Prone Area

Next to revenue recognition, accounting for expenses gives accountants more headaches than any other type

of transaction. In 2000, the Public Oversight Board's Panel on Audit Effectiveness Report and

Recommendations found that, among the seven most frequeny misstated transactions and accounts,

expenses ranked second behind revenue. Several years ago, this author analyzed common pitfalls in die

revenue area ("Auditor Skepticism and Revenue Transactions," The CPA Journal, August 2002). The author

has now analyzed recent SEC Accounting and Auditing Enforcement Releases (AAER) that deal with expense

misstatements. The study is confined to AAERs issued in the 2000-2007 period. A discussion of the techniques

used to misstate expenses can provide lessons to auditors that may prove helpful on future audits.

Nature of Expenses

The Financial Accounting Standards Board's (FASB) Statement of Financial Concepts 6 defines expenses as

follows:

[O]utflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from

delivering or producing goods, rendering services or carrying out other activities that constitute the entity's

ongoing major or central operations.
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A profit-oriented entity is in business to generate revenues, and must make sacrifices to do so. When those

sacrifices or costs convey no benefits to future periods, they must be accounted for as expenses. In some

cases, the sacrifice is evidenced by a cash outflow, such as paying the current month's utility bill. In other

cases, the sacrifice consists of a promise to pay for a product or service at some future point in time.

Accountants must analyze the sacrifice and determine whether future periods will benefit as when equipment is

purchased, or whether, as in the case of paying the current month's utility bill, the benefits are used up in the

current accounting period. If the benefits are used up, the sacrifice must be allocated to expense accounts and

matched against revenues to determine the operating profit for the current period. Where the sacrifice entails

future service potential for the company, accountants must measure the portion of the sacrifice that provides

future benefits and defer those amounts to future periods in the form of assets. In many cases, the critical issue

for accountants is to determine how much of the sacrifice should be expensed currently and how much should

be deferred to future periods.

Of course, measuring expenses and assets is not always clear-cut. Widi equipment, one must make estimates

regarding the life of the asset, its salvage value, the appropriate depreciation method, and whether the asset's

carrying value is impaired. A misstep with any of these decisions can cause potential misstatements on the

income statement and balance sheet. Recent AAERs indicate that numerous misstatements are occurring, and

unfortunately, these are often deliberately planned by higher management.

Techniques of Expense Misstatement

A search of the SECs database of AAERs issued during the 2000-2007 period identified approximately 185

releases containing instances of expense misstatement. These are categorized in Exhibit 1 and detailed below.

Improper deferral of expenditures. The review of AAERs indicates that some companies are falling into the

deferral trap. Exhibit 1 shows that almost 30% of the AAERs dealt with improper deferrals. It is only proper to

defer recognition of expenses to future periods when related services or benefits will be received in future

periods. Too many companies are submitting to the temptation to delay recording expenses even though there

are no future benefits to be enjoyed.The majority of improper deferrals consist of ordinary operating expenses. Controllers and CFOs are keenly

aware of the importance of their operating margins and how closely margin trends are evaluated by securities

analysts. For most companies operating expenses consist of three categories: selling, general and

administrative (G&A), and research and development (R&D). Typically, these expenditures relate to current-

period operations.

A possible exception is advertising costs that arguably might enhance sales in future periods; however, due to

the uncertainty as to whether and to what degree future-period revenues benefit from current advertising, the

general rule is to expense such costs in the same period the advertisements are run. The AICPA's SOP 93-7

allows companies to defer advertising expenses to future periods in very limited situations where a firm candemonstrate the following:

* Advertising is incurred for the purpose of obtaining sales to customers who can be shown to have responded

specifically to the advertising.

* Such costs result in probable future economic benefits.

The business must be able to provide persuasive evidence of the future revenue that the advertising costs will

generate. Persuasive evidence consists of verifiable historical patterns of past results from simiar efforts.

Paragraph 48 of SOP 93-7 requires that deferred advertising costs be subjected to a recoverability test on each

balance-sheet date. The carrying value must be compared to the expected future net revenues and, if

necessary, written down to an amount that does not exceed future net revenues. Unless the future revenues

and costs can be objectively estimated, the advertising costs must be expensed immethately.

AAER 1257 discusses an Internet service provider's attempt to expand its customer base by providing millions

of computer disks containing startup software to potential customers. The firm deferred expensing the majority


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of these marketing expenditures, which allowed it to turn an operating loss into an operating profit The critical

accounting question was whether the SOP 93-7 requirements for deferral were met. The SEC stated that the

company would have to estimate its future subscriber retention rate, future revenues, and future costs in order

for it to objectively apply the recoverability test Since the company operated in a volatile, developing market that

was subject to unpredictable events, the SEC concluded that reliable forecasts could not be made; thus, the

advertising costs should have been expensed when incurred.

Like advertising, R&D expenditures should normally be expensed as incurred; however, deferrals are

sometimes permitted. FASB Concepts Statement 2 allows R&D costs that have alternative future uses as well

as costs that are incurred beyond the development stage to be capitalized.

AAER 1297 deals with a manufacturer of military light aircraft that attempted to reconfigure a military aircraft,

originally designed for the U.S. Army, for possible export to Taiwan. The firm incurred substantial tooling and

prototype construction costs and capitalized those costs rather than treating them as expenses. The decision to

capitalize was based on three arguments: 1) the endeavor had progressed beyond the R&D stage; 2) the costs

of building the prototype were not R&D because the only change was to modify the outer appearance of an

existing helicopter; and 3) both the tools and prototype had alternate future uses.

The SEC rejected all three arguments. Since none of the aircraft were ever produced, the tooling and prototype

costs must have occurred in the R&D stage. As for the second argument, the work to alter the old version of me

aircraft was more than routine, ongoing efforts to modify an existing product, because the prototype had to be

flight tested to see if it met commercial expectations. Finally, the new prototype had no future alternative use

because it was to be disassembled and analyzed after the test flight

The primary lesson to be drawn from these two AAERs is diat both accountants and auditors must realize that

operating expenditures normally are not deferred to future periods. Accountants should depart from me norm

only after careful analysis of the circumstances. Auditors must view capitalized operating costs as a red flag andexamine the deferral with extreme skepticism. Intuitively, an R&D project that never results in a finished product

must not have exited the R&D stage, and any costs should be expensed. Before accepting the deferral of any

normal operating cost, an auditor must obtain objective, verifiable evidence that GAAP requirements have been

met; namely, that future benefits will result from the deferred costs and can be estimated within a range of

reasonableness. For example, it is possible that advertising deferrals might be supported by contracts or letters

of intent from customers attracted by the advertisements.

Impairments not recognized. Even when costs are properly deferred as assets, one must still be aware of

possible impairments. SFAS 144 mandates that accountants must be alert for conditions which could indicate

that impairments of recorded values have occurred, and describes a two-step process for determining andmeasuring the loss. Recent AAERs indicate that failure to record impairment losses is a prevalent problem. This

failure is similar to improper deferrals, because a loss in asset values has occurred yet the overstated values

are carried forward improperly to future periods.


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AAER 2578 describes an aerospace/ defense contractor that encountered unfavorable market conditions during

the late 1990s as a glut began to develop in the used aircraft market As used planes were traded in, they had to

be repaired or refurbished, and these costs were capitalized, pushing up me book value of the planes. As the

glut became worse, the book value of tiie assets became impaired The company decided to deal widi the

problem by using acceleration depreciation to lower the excessive carrying values, but the SEC deemed this an

inadequate response, as impairment losses were being deferred improperly. In 2000, a group of outside

auditors reviewed the valuations of the used planes and informed management of a substantial excess of book

values over fair market values. The auditors further criticized the firm's practice of recording losses only when

planes were leased or sold instead of when the planes were returned or repossessed. At the end of 2000, the

company performed an impairment analysis, but adopted an improper pooling approach rather than measure

the loss on a plane-by-plane basis as required by Generally Accepted Accounting Principles (GAAP). This

allowed losses on high-book-value assets to be offset by "cushions" on low-book-value aircraft Although the

company was warned by the auditors that the pooling approach was improper, it rejected an auditor-proposed

adjustment on grounds of immateriality.While accountants must be wary of adverse economic conditions, asset impairments can also result from

decisions made by management. AAER 1579 describes a national retail drug chain that decided to capitalize

the substantial costs incurred in searching for new store sites. These included legal, architectural, and other

professional fees. At times, management would decide to abandon plans for a particular site, which meant that

the capitalized costs should have been written off in the period that the decision was made. Instead of writing off

the entire cost immediately, however, the company violated GAAP by writing off a fixed portion of n asset each

mondi.

Auditors must be skeptical of asset values, especially with regard to long-term assets where original costs may

become partially or completely impaired SFAS 144 lists several factors, such as changes in the planned use of

the asset or changes in the economic environment, which generally indicate that asset values have become

impaired. In some of the cases depicted by AAERs, auditors detected the overvalued assets and proposed

adjustments, but allowed tiieir clients to forego the adjustments because they were deemed immaterial. In

AAER 2578, a company rejected the proposed auditor adjustment that would have lowered operating income by

7%, a number that many investors would consider material. Even where the quantitative amount of the

adjustment is not large, auditors must consider qualitative factors, such as the effect on operating trends or the

impact on key segments of the company, before passing on the adjustment

Netting and camouflaging expenses. More than 30 of the AAERs involved management efforts to hide

expenses by misclassifying them or by netting them against gains from the sale of assets. While netting does

not change net income, it is useful in manipulating key profit numbers (e.g., gross profit) and in hiding

unfavorable trends, especially with regard to operating expenses. For example, a company that lowers general

and administrative expenses by offsetting them against gains can appear to be tighdy controlling expenses.


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AAER 1405 discusses a transaction in which an SEC registrant exchanged a privately held subsidiary for

shares of a publicly held entity. The exchange resulted in a $160 million gain to the registrant which was used to

offset operating expenses. To make matters worse, the company made no disclosure of netting the gain and

expense accounts. The result misled investors into tiiinking tiat the company was keeping a tight lid on

expenses. Because of this tendency to distort operating results, GAAP prohibits netting of revenue and expense

transactions.

The SEC has dubbed a similar approach to expense manipulation as "geography rear- rangement" Under this

approach, companies compute historical ratios of particular expense accounts to some base number, such as

net sales or total operating expenses. Expenses are ttien moved from one line item to anotiier to make it appear

that each account is in line widi prior-year results. The same company that used the netting process described

above used reclassification entries to move millions of dollars between line items on its income statement, mus

covering up unfavorable fluctuations that would draw investor attention. For example, if repair expenses tripled,

this fact could be hidden by reclassifying part of the repairs to other expense accounts.

Sometimes a business may want to control a specific expense account because analysts focus on tiat line item.

For example, an online retailer of luxury goods realized that analysts focused heavily on the company's

customer acquisition costs. The retailer transferred a material amount of marketing expenses which were usedto calculate customer acquisition costs into a depreciation account that had no effect on acquisition costs. In a

similar fashion, transferring non-depreciation expenses into depreciation or amortization accounts can improve

EBITDA numbers, another item that many investors consider important

A company's gross margin is anotiier critical measurement of performance. One company decided that an easy

way to improve its gross margin percentage was to simply transfer part of its cost of goods sold (COGS)

account to an operating expense account. AAER 2475 describes a transfer of millions of dollars from COGS to

R&D expenses for the sole purpose of improving gross profit margins.

The AICPA' s Statement on Auditing Standards (SAS) 106 instructs auditors to verify the chert's assertion of

proper classification and full disclosure of relevant information. Analytical procedures may serve as a startingpoint, but auditors must also perform adequate detail testing of proper account classification. Unusual accounts

such as suspense, clearing, and gain or loss accounts must be analyzed carefully to verify that they have not

been used to hide expenses that belong in other parts of the income statement Finally, for clients that export

products, auditore should be aware tiat a so-called marketing expense might be a bribery payment Of the 32

AAERs containing expense misclassifications, 25% involved disguised payments that the SEC considered to be

violations of the Foreign Corrupt Practices Act.

Improper charges to reserve accounts. Several companies violated GAAP by setting up unnecessary reserves

to cover unspecified, general risks and using them to absorb future business expenses. These are often

referred to as "cookie jar" reserves because once a CFO realizes that the target earnings are not going to be

achieved, the income deficiency can be erased by either audiorizing journal entries to transfer reserve amounts

direcdy into income or crediting operating expenses and charging reserve accounts.

GAAP prohibits a business from establishing reserve accounts to cover general, unknown business risks. GAAP


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determined with skepticism and obtain an understanding of the model used to estimate the expense. The

model's primary assumptions must be thoroughly tested to verify their reasonableness.

The Red Flags Are There

In some ways, the findings of this review of 185 expense-related AAERs are similar to tiiose in the 2003 study of

revenue-related AAERs. First, many of the AAERs reveal that auditors overlook red flags that signal a higher

probability that something is amiss with the chert's financial statements. Some common red flags that should

put auditors on a higher level of alert are topside adjustments, journal entries with no documentary support,

entries made late in the accounting period and unusual entries such as systematic debits to reserve accounts or

the use of atypical accounts such as contra expense accounts. In particular, topside adjustments are often used

to misstate expenses; AAERs involving Cendant, Nortel, Waste Management, and WorldCom, among others,

illustrate the riskiness of these corporate-level adjustments.

Second, auditors often identify the red flags, yet they fail to react accordingly. In many of the AAERs, the SEC

would cite the auditors for failing to modify the audit program to respond to the known risks. Audit working

papers should include documentation of how the nature, timing, or extent of the audit tests was tailored to

address the identified red flags. In too many cases, auditors simply relied on client representations rather than

perform relevant competent substantive tests.

Third, at least in some of the cases, the auditors identified misstatements and proposed adjustments, yet failed

to require the client to make the adjusting entry. The most common reason for passing on the adjustment was

materiality. Ostensibly, the client would convince the auditor that the misstatement was not material to the

overall earnings results. It appears that auditors are prone to overlook me qualitative aspects of materiality and

pass on adjustments that are not quantitatively material. The SECs Staff Accounting Bulletin (SAB) 100

emphasizes that materiality must be evaluated both quantitatively and qualitatively.

Fourth, many of the audit deficiencies resulted from the auditors' apparent unfamiliarity with GAAP and other

professional standards. Failure to ascertain that GAAP accounting was being followed was a common charge of

the SEC. Auditors must reemphasize the importance of staff familiarity with relevant GAAP/GAAS literature.Exhibit 3 cites key professional standards that are relevant to the five key areas of expense misstatements.

Auditors can and must improve their ability to detect material misstatements in financial statements. Just like

revenues, expenses are prone to misstatement. Auditors must be cognizant of the methods of misstatement,

and design their audit programs accordingly. The AICPA' s Audit Risk Alerts are useful in spotlighting potential

problems, but the AICPA should consider issuing an SAS that focuses on expense-transaction auditing

problems. An audit guide similar to the one on revenue recognition would be helpful, as would continuing

education courses that address accounting for expenses and related audit problems. Auditors can and must

improve their skills in this troublesome area if they are to meet public expectations.

Sidebar

Sometimes a business may want to control a specific expense account because analysts focus on that line

item.

Sidebar

Auditors should view systematic charges to reserve accounts as a red flag, and should ask clients to justify

these charges by providing supporting evidence.

AuthorAffiliation

Jim Martin, PhD, CPA, is a professor of accounting at the University of Montevallo, Montevallo, Ala.

Subject Costs; Financial statements; Auditors; CPAs; Statements on auditing standards;

Location United States--US

Classification 9190: United States; 4130: Auditing


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Publication title

The CPA Journal

Volume 79

Issue 1

Pages 26-31

Number of pages 6

Publication year 2009

Publication date Jan 2009

Section ACCOUNTING & AUDITING: accounting

Publisher New York State Society of Certified Public Accountants

Place of publication New York

Country of publication United States

Publication subject Business And Economics--Accounting

ISSN 07328435

Source type Scholarly Journals

Language of publication English

Document type Feature

Document feature Tables Illustrations

ProQuest document ID

212238058

Document URL http://search.proquest.com/docview/212238058?accountid=17242

Copyright Copyright New York State Society of Certified Public Accountants Jan 2009

Last updated 2011-07-20

Database ABI/INFORM Complete,Accounting & Tax

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Accounting for Expenses