GODFREYHODGSONHOLMESTARCACHAPTER 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)

Expenses definedThe decrease in value pertains eventually to the outflow of cashExpenses encompass losses as well as expenses which arise in the course of ordinary activitiesThe distinction between abnormal and extraordinary items is no longer permitted

*

Expenses definedTo make a definition of expenses operational, it must be associated with a physical activity of the entity - something it doesproduction and sales generate revenue and the using up of goods and services in support of those functions causes expenses to occur*

Changes in assets and liabilitiesExpenses represent a value changeFramework definition of expenses refers to outflows or depletions of assets or incurrence of liabilitiesFramework makes no reference to the relationship of expenses to revenue

*

Expenses and costsSometimes an expense is referred to as an expired costThe using up of assets entails a cost - expense - to the entityIf there is no cost to the firm there is no expense*

Expense recognitionThe recognition criteria for expenses are consistent with those of the other accounting elements*

Expense recognitionAn expense is recognised ifit is probable that any future economic benefit associated with the item will flow to or from the entity; andthe item has a cost or value that can be measured with reliabilityprudence and neutralityfreedom from material error and bias, represent faithfully

*

Expense recognitionThe decrease in future economic benefits relates to a decrease in an asset or an increase in a liabilityrecognition of an expense occurs simultaneously with the recognition of an increase in a liability or a decrease in assets*

Expense measurementIn measuring expenses a number of decisions have to be made as to how expenses should be allocated over periods of resultant revenueaccrual accountingmatching expenses against revenues in the period to which they relate*

Allocation of expensesRevenue = accomplishmentExpenses = effortFor 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*

Allocation of expensesThe accountant must decidewhether a cost pertains to future revenues and therefore should be deferredwhether a cost pertains to current revenues and therefore should be written-off against that revenue in the current periodwhether a cost, although incurred and not yet paid, is related to current revenue and therefore should be accrued*

Allocation of expensesThe matching process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other eventssales and cost of goods sold*

Allocation of expensesIn practice, matching isvery difficult to doinvolves a great deal of judgementarbitrary*

Allocation of expensesThree basic methods of matchingassociating cause and effectsystematic and rational allocationimmediate recognition*

Associating cause and effectThe ideal way of matching is by associating cause with effectCause and effect relationships are very difficult to provereasonable observation*

Systematic and rational allocationAn alternative is to use a systematic and rational allocation procedureassociate expenses to segments of timethe expense is assumed to correlate with the revenue for that perioddepreciationRequires estimates and assumptions which are usually arbitrary

*

Immediate recognitionUsed if neither of the previous two can be usedRecognise the outlay immediately as an expenseadvertising expensesresearch expenditureimpairment expenses*

Criticisms of allocationsThe doctrine of conservatism means that expenses, losses and liabilities are recognised as soon possible, even if evidence for them is weakThe asymmetrical treatment of revenue and expenses may create a conservative bias and misleading financial statementsPersonal incentives may influence managers judgement in the allocations process*

Criticisms of allocationsThe allocations (matching) process is an essential part of accounting practiceThe process has made the balance sheet secondary to the income statementThe balance sheet has become a repository for unexpired costsMost of what accountants put in accounting reports is rubbish*

Criticisms of allocationsThe allocation problemThomas allocations in accounting do not meet the following criteriaadditivityunambiguitydefensibility

*

Criticisms of allocationsAllocations are defended by accountants on two groundsa 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 periodsallocated data serves a useful purpose because readers of accounting reports, which include allocated data, find them useful*

Criticisms of allocationsBut, allocations are incorrigible - Thomasthey are not capable of verification or refutation by objective, empirical meansthe patterns of allocation do not exist in the real-world; they exist only in the minds of accountantsan inputs individual contribution to the output cannot be known because all the inputs interact with each other to generate an outputempirical studies do not demonstrate that allocations are useful

*

Criticisms of allocationsAlternative approaches suggestedexit price accounting no allocations

*

Defence of allocationsChange the objective of allocations Continue with allocations only if the benefits outweigh the costs of doing so*

Challenges for accounting standard settersThe IASB is aware of the allocations problem and is tackling it in its current projectsThe plea is for reasonableness or appropriateness and not for objective evidencecontradicts the recognition of revenueconservatism

*

Issues for auditorsAuditors face issues surrounding the distinction between expenses and assets, the period in which expenses are recognised, and appropriate measurement of expensesbig bath and cookie jar accountingconcepts such as matching and conservatism are not helpful if they distort information and reduce its utilitymanagers have incentives to distort expenses*

Summary The nature of expenses and the way they are definedRecognition criteria and the matching concept as they are applied to expenses in the accrual accounting systemCriticisms of the matching process and accountants use of allocationsChallenges for standard settersIssues for auditors *

Key terms and conceptsExpensesDefinitionsEconomic benefitsRecognition criteriaProbable and reliableExpense measurementMatching Allocation of expensesAssociating cause and effectSystematic and rational allocationImmediate recognitionCriticisms of allocationsConservatism

*

*

**