LOS D requires us to:
describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis.
a. As per the IASB definition, expenses are:
i. decreases in the economic benefits,
ii. in the form of:
# outflows,
# depletion of assets, and
# the incurrence of liabilities
iii. that results in a decrease in equity.
b. The recognition of expenses is mainly governed by the matching principle or matching concept. The costs should be matched with the revenues.
c. There are basically two types of costs that need to be recognized:
i. The product costs, and
ii. The period cost.
d. The product costs are mainly embodied in the cost of goods sold and the value of inventories. Whereas, the period costs are all the other costs that are a part of income statements such as the general, selling, and administration cost.
1. Specific Expense Recognition Applications
Let us now discuss specific items of expense and their recognition methodology and requirements as specified by accounting standards.
1.1. Inventory
a. There are mainly three methods of valuation and recognition of inventories. They are:
i. FIFO. Under this method the inventories are valued on a first-in-first-out principle; i.e. the goods that are purchased first are assumed to be the first sold. For example, say the goods are purchased and sold by a trader in the course of his business as follows:
Purchases were:
Date |
Quantity |
Price |
January 01 |
200 |
50 |
January 07 |
270 |
52 |
January 26 |
350 |
51 |
And the units were sold as follows:
Date |
Quantity |
Price |
January 05 |
100 |
60 |
January 27 |
500 |
64 |
The balances in the inventory account on the relevant dates, according to the FIFO method would be:
Date |
Quantity |
Price |
COGS |
Balance |
January 01 |
200 |
50 |
|
$10,000 |
January 05 |
-100 |
60 |
$ 5,000 |
$ 5,000 |
January 07 |
270 |
52 |
|
$ 19,040 |
January 26 |
350 |
51 |
|
$ 36,890 |
January 27 |
-500 |
64 |
$ 25,670 |
$ 11,220 |
ii. LIFO. Under this method the revenue is recognized on the last-in-last-out basis; i.e. the inventory purchased last is assumed to be sold first. In the above example the balances of inventory and the cost of goods sold on the specific date would be as follows:
Date |
Quantity |
Price |
COGS |
Balance |
January 01 |
200 |
50 |
|
$10,000 |
January 05 |
-100 |
60 |
$ 5,000 |
$ 5,000 |
January 07 |
270 |
52 |
|
$ 19,040 |
January 26 |
350 |
51 |
|
$ 36,890 |
January 27 |
-500 |
64 |
$ 25,650 |
$ 12,800 |
iii. Average Cost Method. Under this method, the sales and inventory are measured at the average rate of purchase of the goods. Thus, as per this method, the balances of the inventory and cost of goods sold in the above example would be:
Date |
Quantity Purchased /Sold |
Average Price of Balance Inventory |
COGS |
Balance in Inventory Account |
January 01 |
200 |
50 |
|
$10,000 |
January 05 |
-100 |
60 |
$ 5,000 |
$ 5,000 |
January 07 |
270 |
51.46 |
|
$ 19,040 |
January 26 |
350 |
51.24 |
|
$ 36,890 |
January 27 |
-500 |
51.24 |
$ 25,618 |
$ 11,272 |
b. U.S. GAAP recognizes all the three methods discussed above for the valuation of inventory and expense recognition. Whereas, IFRS does not recognize the LIFO method.
c. The preparers of the books of accounts may follow any of the following strategies for valuation of the inventory and recognition of the cost of goods sold:
i. Value the inventory correctly and let the cost of goods sold fall where they may; or
ii. Value the cost of goods sold correctly and let the inventory fall where it may.
1.2. Doubtful Accounts
The doubtful accounts are those accounts receivable whose collectability is not assured or is doubtful. The principle of conservatism requires that either such accounts be written off as bad debts or be disclosed properly, so that users of the financial statements may make a proper judgment about the financial position of the reporting entity.
There are two ways in which these doubtful accounts may be treated:
a. Direct write-off method. According to this method, there is no need to make the provision with respect to the same. Instead, these accounts should directly be written off when these accounts finally become bad.
b. Make Provision. Under this method, an estimate is made for the amount of accounts receivables that are expected to turn bad and will not be collected. The value of such estimates is typically derived from experience.
NOTE: In case of warranty sales as well, for the recognition of warranty expense, any of the above two methods may be followed.
1.3. Depreciation / Amortization Expense
a. Depreciation / Amortization is usually charged to the tangible/intangible long-lived assets.
b. IFRS provides two methods of recognizing expenses and disclosing the assets in the balance sheet. They are:
i. Cost Method. Under this method, the assets are recorded at the historical cost, as reduced by the accumulated depreciation (which is a contra account for the asset account). So the asset is basically reported at the book value, which is the historical cost as reduced by the accumulated depreciation.
ii. Fair Value. The asset is revalued at the reporting date under this method to reflect the fair value as on the same date.
c. The fair value method of reporting the asset is not permissible under U.S. GAAP.
d. There are many ways of calculating depreciation. The most important of them being:
i. Straight Line Method. Under this method, the asset is depreciated by an equal amount each period over the life of the asset.
ii. Accelerated Depreciation. There are many ways of providing the accelerated depreciation; like the double-declining method, the sum of digits method, etc. Under these methods, depreciation is charged at a higher rate in the earlier periods of the life of the asset.
iii. Units of Production Method. Under this method, the asset is depreciated according to its use; i.e. according to the number of units of production during the period in comparison to the units expected to be produced during its lifetime.
e. Amortization is provided on the assets with definite life; for the other intangibles with indefinite lives such as goodwill, the value is tested annually for impairment.