Basic principles of expense recognition

A company recognizes an expense in the period in which consume the economic benefits arising from the expenditures or loses some previously recognized economic benefit. The fundamental principle underlying expense recognition is the matching principle which requires matching expenses with revenues. It means that expenses should be recognized in the period in which the associated revenues are recognized. However, some costs cannot be linked directly with some performance obligations related to revenue. Such expenses are called period costs, and they should be recognized in the period in which they are incurred. Costs that are expected to generate economic benefits in the future are capitalized and expensed on a systematic basis.

Recognition of inventory expenses

For many businesses, the manner in which inventory costs are charged to the cost of goods sold is important. The most straight-forward method identifies the exact units which are sold and charges their cost against revenue. This method is called specific identification method. Since it is not feasible in reality, accounting standards require companies to adopt some cost formulas (or cost flow assumptions) to allocate inventory costs to COGS.

There are three methods: first-in-first-out (FIFO), weighted average, and last-in-first-out (LIFO). US GAAP allows all three methods while IFRS allows only the first two.

First-in-first-out (FIFO)

FIFO assumes that items purchased or manufactured first are sold first (for example, in the case of perishable goods). Hence, the units in the closing inventories are the more recently purchased or manufactured. When prices are rising, it causes the cost of goods sold to be lower, and inventories balance to be higher than the other two methods.

Last-in-first-out (LIFO)

LIFO assumes that most recently purchased units are sold first (for example, in the case of lumber in which units are stacked such that the newest units are easiest to deliver). In a rising price environment, LIFO causes COGS to be higher and inventories to be lower, and vice versa.

Weighted-average method

The weighted average method allocates cost to a unit sold based on the per-unit cost calculated based on the total cost of units available divided by total units available. It results in COGS and inventories balance in-between those under the two methods. In an inflationary environment, LIFO causes net income and taxes to be lower.

Doubtful accounts and warranties

One approach to record loss resulting from default by customers is to record it when it occurs in what is called the direct write-off method. However, this would not be consistent with the matching principle. A better approach is to estimate and record doubtful debts as an expense at the time of recognition of revenue (and not as a reduction from revenue). This estimation can be based on a percentage of sales, receivables or receivables overdue by a specific time.

Similarly, companies may offer warranties which obligates them to repair or replace the products they sell if it turns out to be deficient. In accordance with the matching concept, companies need to estimate the potential warranty costs and record them as an expense in the period in which sales are recorded and constantly update them in light of new information.

Depreciation and amortization

Depreciation is the process through which the cost of tangible long-lived assets is allocated over the period during which they are expected to provide economic benefits. Amortization refers to a similar process that applies to intangible long-lived assets with finite useful lives.

Cost model vs revaluation model

IFRS allows two models for valuing property, plant, and equipment (tangible fixed assets): the cost model, in which PPE is held at historical cost less accumulated depreciation, and the revaluation model, in which PPE is held at fair value. IFRS requires depreciation of each component separately and an annual review of residual value and useful life. US GAAP neither allows the revaluation model nor it requires component depreciation or annual review of residual value and useful life.

Depreciation methods

The depreciation method should reflect the pattern in which economic benefits are obtained from an asset. IFRS does not prescribe a particular method for computing depreciation.

Straight-line method

The straight-line method allocates the cost of an asset evenly over its useful life. Estimates of residual value (salvage value) and useful life are important in determining annual depreciation expense.

Accelerated depreciation method

Accelerated depreciation methods are those which charge higher depreciation in earlier years. For example, depreciation under the diminishing balance method (also called the declining balance method) is calculated as follows:

  • Determine the straight-line rate (as 1 divided by useful life).
  • Identify the acceleration factors (150% or 200% for double declining balance)
  • Apply the product of straight-line rate and acceleration factor to the undepreciated balance of the asset at the start of each period (also called net book value)
  • Stop depreciation when salvage value is reached.

Under the accelerated depreciation methods, there is a higher depreciation expense in the early years than the straight-line method. Accelerated depreciation is relatively more conservative.

Amortization

In most cases, an intangible asset is amortized on the straight-line method under the assumption of zero residual value. Goodwill is not amortized but is tested annually for impairment. If the fair value of an intangible asset is lower than its book value, its book value is reduced, and impairment expense is recorded.

Implications of expense recognition principles for financial analysis

Recognition of expenses by a company is subject to a significant number of judgments and estimates. An analyst needs to check whether there is consistency in estimates used by a company. If not, he should find out whether there are sound reasons for any changes. It is because the company might be using changes in estimates to manipulate its earnings. For example, the percentage of doubtful debts as a percentage of sales should change only if there is an underlying improvement in the collection track record. It is useful to find out the monetary effect of any differences in estimates to adjust expenses when comparing companies.

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