When expenses should be recognized in the financial statements?

Expense Analysis

There is various ways to analyze expense, there for it is also a way to Expense Analysis.

Expense Analysis

o Expenses are the economic resources that have been consumed or have declined in value

o Firms incur expenses to acquire or produce products or services that are sold, to manage firm, market the firms

Areas of analysis:

  • When expenses should be recognized in the financial statements?
  • Should they be recognized when the resources are used?
  • Should they be recognized when the firm is billed for resources?
  • Should they be recognized when payment for resources is made?
  • Should they be recognized when the revenues generated from using the resources are recognized?

o Matching and conservatism principles

  • Resources directly associated with revenues are recorded in the same time period as revenues are recognized
  • Resources that are more closely associated with a specific time period are recorded in that time period
  • All costs are recognized as an expense when they are incurred or can be reasonably estimated

o Cash outlays are a poor indicator of resource use

  • when a firm acquires resources but has yet to use them
  • when a firm uses resources but has yet to pay for them

Recognizing expenses at the outlay of cash may be misleading and provide the management incentive to increase profit of the company by deferring payment

Criteria for recognizing expenses

o Resources consumed have a cause and effect relation with revenues recognized during the period

  • Matching principle views expenses as the cost of consumed resources that have a cause and effect relation with revenues. Ex: COGS
  • Easier to identify whether the products or services are profitable

o Resources have no cause and effect relation with revenues but are consumed during the period

  • Recorded during the time of consumption. Ex: G&A expenses, marketing expenses

o There is a decline in future benefit expected from resources

  • Follows conservatism principle
  • Ex: when benefits become difficult to estimate with reasonable certainty or write downs of impaired asset

Challenges of expenses

o Resources provide benefits over multiple periods

o Resources are consumed, but the timing and amount of future payments are uncertain

o The value of resources consumed is difficult to define

o Unused resources have declined in value

Challenge one: Resources provide benefits over multiple periods

o Example: Outlays for plant and equipment, research and development, advertising, drilling oil and gas wells

o How to allocate the cost of resources?

o Should it be allocated equally over their useful life?

o Should it be recorded conservatively when they are incurred?

Fixed asset depreciation

  • Fixed asset are directly or indirectly related to the revenue generation process
  • According to GAAP, managers should determine the expected useful lives of the assets and expected salvage value at the end of its life in order to allocate the costs of fixed assets over their useful lives in a systematic manner
  • Useful life of assets are determined considering the risk of technological obsolesce and physical use, business strategies, experience in operating, managing and reselling those types of assets.
  • Under straight line depreciation, same amount of depreciation is reported over the life of the asset
  • In case of accelerated depreciation, higher amount of depreciation is reported in the early years of asset, but less amount is reported at the end of the asset’s life
  • A third depreciation method, units of production method is applied for the assets whose lives can be measured in physical units. Depreciation = Cost of asset x % of lifelong physical capacity. Applied by natural resources company
  • Management uses its judgment in selecting depreciation method.

o Goodwill amortization:

  • Goodwill only arises when one firm acquires another firm using purchase method
  • Goodwill represents the premium paid for the target’s intangible assets, like: brand names, research and development, customer base, superior management, well trained employees, patents, other source of superior performance
  • For goodwill, cause and effect relationship with revenues is less obvious than fixed assts as

o Future benefit of goodwill is less clear than that of fixed assets

o Goodwill may arise due to overpayment by the acquirer

  • Different countries follow different methods for goodwill amortization

o In the Netherlands, goodwill is not amortized against income, rather it is written off against equity

o In US, it is amortized on straight line basis for 40 years, In Japan for 5 years, in Germany for 4 years

o In UK goodwill is reported as asset and amortization is reported if it is impaired

  • The expected value and economic life of goodwill depends on:

o The ability of the acquirer to price the intangible asset of the target avoiding overpayment

o The ability of the acquirer to integrate the target without destroying its intangible asset that it purchased, like: superior management, existing customers, key employees

o Strategy and strategy implementation of the new firm

o Research and Development Outlays

  •  Should be reported when revenues are generated against the outlays
  •  According to SFAS 2, as R&D is very uncertain, it should be recorded as expense when incurred.
  •  Completed R&D purchased from another company should be capitalized and amortized over its useful life
  •  Software development costs are capitalized upon completion of a detailed program design plan or working model
  •  Management can apply its judgment for reporting R&D

o Advertising Outlays

  •  Accounting standard demands to report advertising out5lays as expense when it is incurred
  •  Future benefit of advertising depends on firm’s and its competitors’ pricing and promotional strategy, firm’s market position, overall industry condition, etc
  •  SFAS 60 and SFAS 120 require insurers to capitalize these outlays and to expense them over the life of the contract
  •  Outlays for direct response advertising can be capitalized if customers have responded directly to the advertising campaign and future benefits of the outlays are reasonably certain

Challenge Two: Resources are consumed, but the timing and amount of future payments are uncertain

o Pension and environmental hazard

o How should these type of commitments be recoded?

o Should an expense be estimated for the expected obligation or for present value of the expected obligation?

o If so, how should the error’s of management's forecast of these obligations and interest rates be reflected?

o Should the recording the expense be delayed unlit the timing and amount of the obligation can be determined more accurately?

o Pension and other post retirement benefits

  • Management has to forecast current employees’ future working lives with firm, their life expectations, retirement ages, expected cost of future benefits, etc in order to determine the present value of the future benefits available for the employees
  • The value is amortized as a benefit expense by sing a straight line method over the employees expected working lives with the firm

o Environmental cost

  • How should it be recorded? As a one time charge when it is recorded as liability or be spread out over the clean up period? As an extraordinary item? As a non-operating item? As a part of normal operation?
  • According to SFAS 5, it should be recorded as operating expense when liability is recoded, it can’t recoded as extraordinary item

Challenge Three The value of resources consumed is difficult to define

o Cost of sales

  • If a firm purchases or manufactures products at different costs and then sells some of those units , it faces a question of determining the cost of units that were sold and the cost of units remaining in inventory
  • For some types of products, the valuation of cost pf sale and inventory can be easily resolved since the specific units that are purchased and sold are identifiable. Ex: Auto dealership
  • For most businesses, it is not feasible to specifically identify each unit purchased and sold. Ex: Auto manufacturers
  • three methods for flow from inventory to cost of goods sold

o LIFO: last units purchased or manufactured are the first units to be sold

o matches recent costs with revenues

o Gives better indication regarding future benefits

o Leads to valuation that are long out of date

o May boost profit by reducing inventory

o FIFO: First units purchased or manufactured are the first units to be sold

o Inventories are valued at recent costs

o Average cost method: Compromise between LIFO and FIFO

Values cost of sales and inventory at the average costs of units

o Several important factors:

o Tax: when costs increases, follow LIFO to reduce tax burden

o Different countries prefer different methods.

o Types of products and inventory define the type of method

o Executive stock option compensation

  • Provided to the top management
  • If option is exercised, how to record the compensation? When and at what value?
  • According to the intrinsic value method of reporting option supports to record compensation as the difference between market price of stock at the date of option granted and exercise price

Challenge Four: Unused resources have declined in value

o Operating asset impairments

  • It is often difficult to assess whether as asset has been impaired and the amount of loss

o Changes in the value of financial instruments

  •  Whether the gains or losses of the financial instruments available for sale should be reflected in the income statement or charged directly to the owner’s equity

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