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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Michael L. Hockenstein Commerce Department • Vanier College
Intermediate Accounting
Thomas H. BeechySchulich School of Business, York University
Joan E. D. ConrodFaculty of Management
Dalhousie University
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-2
Expense Recognition
Chapter 7
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-3
Introduction
Policies must be chosen to recognize expenses
There are areas where generally accepted accounting principles allow significant latitude
Accountants and financial statement users have to be on their toes in this area
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-4
Expense Recognition
Cost, expenditure, and expense General recognition criteria Approaches to expense recognition
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-5
Cost, Expenditure, and Expense
When we agree to pay out cash (or other assets) for goods or services received, we have incurred a cost
When we actually pay the cash, we have an expenditure
When the benefits of the cost have been used and we put that cost (or a portion thereof) on the income statement, we have recognized an expense
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-6
General Recognition Criteria Recognized items must:
meet the definition of a financial statement elementhave a valid measurement basis and amount
Financial statement elements are based on future economic benefits or sacrifices; these must be probable for recognition to be appropriate
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-7
General Recognition Criteria(cont)
Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from an entity’s ordinary revenue generating or service delivery activities [CICA 1000.38]
Asset or expense? if the asset recognition criteria are met, an asset is recorded. If not, an expense is recorded
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-8
Approaches to Expense Recognition
Definitional approach: expenses are created either through the reduction of an asset or the increase in a liability
Matching approach: once revenues are determined in conformity with the revenue principle for any reporting period, the expenses incurred in generating the revenue should be recognized in that period
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-9
Measurement
Recognition is not possible unless there is a reliable amount to record
If the expense has to be accrued at the revenue recognition point, prior to settlement, accurate measurement of the liability, and, by inference, the expense, is a major concern
Another major issue in expense measurement deals with the issue of interperiod allocation: what amortization policies are appropriate?
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-10
Expense Categories
Direct expenses: expenses that are associated directly with revenues, e.g., cost of goods sold
These expenses are recognized at the same time as the related revenues. They can also be called product costs or project costs.
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-11
Expense Categories (cont.)
Indirect costs: expenditures which are not associated directly with revenues, e.g., interest costs and administrative salaries
These are often called period costs
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-12
Specific Expense Policies Two specific expenses:
cost of goods sold amortization
These are important areas: they represent significant expense categories
on many income statements there are potentially material differences in
expense patterns associated with different policies
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-13
Cost of Goods Sold
Management must choose a cost allocation procedure for allocating the total cost of goods available for sale during each period between (1) the cost of goods sold (2) the cost of the ending inventory
Inventory accounting policy determines the flow of costs through the accounting system, not the flow of goods physically in and out of a stockroom
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-14
Underlying Concepts of Cost Flow
Specific cost identification Average cost First-in, first-out Last-in, first-out Comparison of methods Other issues in inventory
costing
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Specific Cost Identification
Each item stocked must be specifically marked so that its unit cost can be identified at any time
Automotive dealers use the specific cost method for two reasons: First, the dealer’s specific cost is an important
determinant of the sales price Second, each car is unique, and
the serial number links it to a specific invoice cost
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-16
Average Cost
The average cost method assumes that the cost of inventory on hand at the end of a period and the cost of goods sold during a period is representative of all costs incurred during the period
(Inventory cost + current purchase cost)Total units on hand
The moving-average method is generally viewed as objective, consistent, and not subject to easy manipulation
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-17
First-in, First-out
The first-in, first-out method (FIFO) treats the first goods purchased or manufactured as the first units expensed out on sale or issuance
Goods sold (or issued) are valued at the oldest unit costs, and goods remaining in inventory are valued at the most recent unit cost amounts
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-18
First-in, First-out (cont.) There are two common rationalizations for the use of
FIFO:FIFO approximates the physical flow of
merchandise and materials–generally speaking, items that are purchased first are sold first or used first in operations
Under historical cost accounting, costs should be matched to revenue in historical sequencethe costs first incurred should be the first that are matched to revenues.
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-19
Last-in, First-out
The last-in, first-out method (LIFO) of inventory costing charges the cost of the most recently acquired items to cost of goods sold
The units remaining in ending inventory are costed at the oldest unit costs incurred, and the units included in cost of goods sold are costed at the newest unit costs incurred, the exact opposite of the FIFO cost assumption
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-20
Comparison of Methods
The impact that the inventory cost flow assumption has on the financial statements depends on whether prices are going up or down
In periods of rising prices, FIFO results in higher inventory balances, lower cost of goods sold, and higher profits
LIFO has the opposite effect: lower inventories and lower profits
Canada Customs and Revenue Agency does not allow firms to use LIFO for tax purposes
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Comparison of Methods (cont.)
Average cost is always in the middle between FIFO and LIFO---the middle inventory value, and the middle cost of goods sold figure
Average cost is allowed for tax purposes, and is likely to result in a lower taxable income than FIFO if prices are rising
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-22
Other Issues In Inventory Costing There is an important issue of determining which
costs to include in inventory and which to treat as period costs
There is a great deal of flexibility in the matter, and it is not unusual for a company to use three different definitions of inventoriable cost: one for internal decision-making
(management accounting), one for income tax purposes, and one for external financial reporting
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-23
Asset Amortization
When an expenditure is made, it becomes either an expense (no future benefit that meets the recognition criteria) or an asset (recognition criteria are met)
Assets do not remain on the balance sheet forever, except for land
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Asset Amortization (cont.)
Some assets are expensed in their entirety at the revenue recognition point---inventory is the best example of this
Some are expensed as they are consumed in the earnings process---supplies
Others are used or consumed in the earnings process over a period of time, and must be amortized, or expensed, gradually
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-25
Asset Amortization (cont.)
Amortization: the periodic allocation of the cost of capital assets over the useful life of the assets
Depreciation: amortization of tangible capital assets, e.g., buildings, furniture, and equipment
Depletion: amortization of natural resources
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Nature of Amortization In referring to capital assets, the CICA Handbook
states that:Amortization should be recognized in a
rational and systematic manner appropriate to the nature of the capital asset. [CICA 3060.31]
In the section on research and development costs, the CICA Handbook states that amortization:
should be charged as an expense on a systematic and rational basis by reference, where possible, to the sale or use of the product or process. [CICA 3450.28]
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Nature of Amortization (cont.)
Amortization expense is not recognized for sudden and unexpected factors, such as damage from natural phenomena, sudden changes in demand, or radical misuse of assets that impair their revenue-generating ability
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Amortization Methods
Amortization (depreciation) alternatives:
straight-line (SL) method units of production methoddeclining balance (DB) methodsum-of-the-years'-digits (SYD) methodsinking fund amortization methods
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-29
Depreciation Methods Used In Practice
Depreciation methods used in practicestraight-line was used by 90%declining balance method was used by 21% units of production was used by 26%.
Why? Industry practiceCompanies are taken with the simplicity of the
straight-line method
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-30
Depreciation Methods Used In Practice (cont.)
Declining balance methods more common: for assets that run significant risk of technological
obsolescence orwhen repair costs are expected to mount up later
in an asset’s life when they must use a form of declining balance
for many assets for tax reporting
Units of production is used in the resource industry
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-31
Deferred Costs
Pre-operating costs Other deferred charges Research and development costs Computer software costs Website development costs Exploration and development costs
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-32
Pre-operating Costs The CICA’s Emerging Issues Committee suggested
that an established company can defer (and amortize) expenditures in the pre-operating period to the extent that:The expenditure is related directly to placing the
new business into serviceThe expenditure is incremental in nature
(i.e., a cost that would not have been incurred in the absence of the new business)
It is probable that the expenditure is recoverable from the future operation of the new business
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Pre-operating Costs (cont.)
Once in commercial operation, the pre-operating expenditures should be amortized
The EIC indicated that this amortization period should not normally exceed five years
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Other Deferred Charges
Section 3070 of the CICA Handbook deals with the disclosure of deferred charges, but recognition concerns are not discussed
Long-term deferred charges are excluded from current assets and reported either as a separate category or under Other Assets on the balance sheet.
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-35
Research and Development Costs
Research: planned investigation undertaken with the hope of gaining new scientific or technical knowledge and understanding
Development: the translation of research findings or other knowledge into a plan or design for new or substantially improved materials, devices, products, processes, systems, or services prior to the commencement of commercial productions or use
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-36
Research and Development Costs (cont.)
Activities included in research:
Laboratory research aimed at discovery of new knowledge
Searching for applications of new research findings or other knowledge
Conceptual formulation and design of possible product or process alternatives
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Research and Development Costs (cont.)
Activities included in development:
testing in search for, or evaluation of, product or process alternatives
design, construction, and testing of pre-production prototypes and models
design of tools, jigs, molds, and dies involving new technology
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-38
Research and Development Costs (cont.) Activities excluded from both research and
development:engineering follow-through in an early phase of
commercial productionquality control during commercial production,
including routine testing of products troubleshooting in connection with breakdowns
during commercial production routine or periodic alterations to existing products,
production lines, manufacturing processes, and other ongoing operations, even though such alterations may represent improvements
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-39
Research and Development Costs (cont.)
Section 3450 of the CICA Handbook recommends that research costs should be charged to expense when incurred
Development costs may be capitalized and amortized if all of the following criteria are met: the product or process is clearly defined and the costs
attributable thereto can be identified the technical feasibility of the product or process has been
established
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Research and Development Costs (cont.)
the management of the enterprise has indicated its intention to produce and market, or use, the product or process
the future market for the product or process is clearly defined or, if it is to be used internally rather than sold, its usefulness to the enterprise has been established
adequate resources exist, or are expected to be available, to complete the project. [CICA 3450.21]
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-41
Computer Software Costs
Accounting issues concerning the costs of developing computer software arise in two different contexts:
(1) Companies develop computer software systems for their internal use, either by developing the software with their own staff or by contracting with an outside developer
Note: Apply the AcSB’s criteria as outlined in the previous section
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Computer Software Costs (cont.)
(2) Companies develop software as a product to be sold to outsiders
Under the FASB standard, software development costs are expensed as incurred until all the planning, designing, coding, and testing activities necessary to establish that the product can be produced to meet its design specifications are completed, or until a working model of the software is completed
Subsequent costs for further coding, testing, debugging, and producing masters of the software product to be duplicated in producing saleable products are capitalized
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-43
Website Development Costs
Website development costs are generally expensed unless there is a long-term benefit , in which case capitalization and amortization is appropriate
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-44
Exploration and Development Costs
Exploration and development (ED) costs are the costs that oil and gas companies and mining companies incur in exploring and developing their resource properties
Exploration: the process of seeking mineral deposits
Development: the process of turning a found deposit
into a productive mine site or oil field
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Exploration and Development Costs (cont.) The accounting for exploration and development costs
varies widelyOne extreme is to treat all ED costs as expenses in
the period in which they are incurredThe more common approach is to defer and
amortize those costs The value of the intangible asset is not the value of the
mineral resources; it is only the cost of getting at them Depletion is usually calculated on a unit-of-production
basis, using the estimated reserves as the denominator in the per-unit calculation
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-46
Enterprises in the Development Stage
Enterprises in the development stage have not begun principal operations
Costs are accounted for by their nature, but are often classified as development costs and are eligible for deferral if the deferral criteria are met
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 7-47
Cash Flow Reporting Of Capitalized Costs
Costs that are accounted for as expenses are included in the cash flow from operations
Costs that are accounted for as assets are included in the investing activities section of the cash flow statement
Amortization on capitalized assets is deducted in determining net income, but is removed from cash flow from operations (either by adding it back in the indirect approach, or leaving it out in the direct approach)