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IFT Notes for Level I CFA® Program

R21 Understanding Income Statements

Part 2


 

4.  Expense Recognition

Expenses are ‘decreases in economic benefit during the accounting period in the form of outflows or depletion of assets or incurrences of liabilities that result in decreases in equity.’ For example, if a company pays rent, its cash reduces and the rent is recognized as an expense.

4.1.     General Principles

Matching principle

The most important principle of expense recognition is the matching principle, under which the expenses incurred to generate revenue are recognized in the same period as revenue. For example, if some goods bought in the current year remain unsold at the end of the year, they are not included in the cost of goods sold for the current year. If they are sold in the next year, they will be included in the cost of goods sold for the next year.

Periodic costs

Expenses that cannot be tied directly to generation of revenues are called periodic costs. They are expensed in the period incurred. For example, the rent paid for office premises are simply expensed in the period for which the rent was paid.

Inventory methods

Accounting standards permit the use of following methods to assign inventory expenses:

  • First in, first out (FIFO)’ assumes that the earliest items purchased are sold first.
  • Last in, first out (LIFO)’ assumes that the most recent items purchased are sold first.
  • Weighted average cost’ averages total cost over total units available.
  • Specific identification’ identifies each item in the inventory and uses its historical cost for calculating COGS, when the item is sold.

Instructor’s Note:

We will learn more about these inventory valuation methods in a later reading.

4.2.     Issues in Expense Recognition

Some issues in expense recognition are:

Doubtful accounts

When sales are made on credit, there is a chance that some customers will default. There are two methods of recognizing credit losses. The first one is to wait for a customer to default and then recognize a loss. This is called the ‘direct write-off’ method. The second is to record an estimate of credit losses (using historical data) at the time of revenue recognition. The matching principle requires the use of the second method.

Warranties

When a company provides warranty, there is a chance that some defective product may need to be replaced or repaired. There are two methods of recognizing warranty expense. The first one is to recognize warranty expense when warranty is claimed.  The second is to estimate a warranty expense (using historical data) at the time of revenue recognition. The matching principle requires the use of the second method.

Depreciation

It is the process of allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. The first method is called the straight-line method, where we expense an equal amount of depreciation in each year of the asset’s useful life. The second method is the declining balance method, where a greater proportion of deprecation is allocated in the initial years and a lower proportion is allocated in later years.

Amortization

It is the process of allocating costs of intangible assets (a non-physical asset) over its useful life. Intangible assets with identifiable useful lives (for example a patent that will expire in a few years) are amortized evenly over their lives. Intangible assets with indefinite lives (for example goodwill) are not amortized. They are tested for impairment annually. If the asset value has come down an expense is recorded in the income statement to bring its value down to the current value.

Instructor’s Note:

Under IFRS, two alternative models are permitted for valuing property, plant, and equipment:

1) the cost model: The asset is reported at its cost less any accumulated depreciation.

2) the revaluation model: The asset is reported at its fair value.

The revaluation model is not permitted under US GAAP. Although the revaluation model is permitted under IFRS, it is not as widely used.

We will learn more about depreciation and amortization in a later reading.

4.3.     Implications for Financial Analysis

A company’s estimates for doubtful accounts, warranty expenses, and depreciation amounts can affect its net income. If a company’s policies result in early recognition of expenses, it can be considered a conservative approach. On the other hand if a company’s polices delay the recognition of expenses, it can be considered an aggressive approach. Using this as well as other information contained in the footnotes or disclosures, an analyst can recognize whether a company’s expense recognition policy is conservative or not. The analyst should also recognize that it is possible that two companies in the same industry have very different expense recognition policies.

5.  Non-Recurring Items and Non-Operating Items

Analysts are generally trying to estimate and assess future earnings of a company. Hence, reporting standards require firms to separate income and expense items that are likely to continue in the future, from items that are not likely to continue. (You will be more interested in items that will continue as compared to one-time items.)

5.1.     Discontinued Operations

A discontinued operation is an operation which a company has disposed of or plans to dispose of.  Net income from discontinued operations is shown (as a separate line item on the income statement) net of tax after net income from continuing operations.

5.2.     Unusual or Infrequent Items

Both IFRS and US GAAP allow recognition of items that are unusual or infrequent (but not both). These items are also called exceptional items i.e. items not “inherent” to the company’s current activities. Examples include restructuring charges and gains/losses from sale of equipment, receipts from a legal case, costs of integrating an acquisition, and impairment of intangible assets, etc. These items are shown as part of a company’s continuing operations.

5.3.     Changes in Accounting Policies

At times, new accounting standards may require companies to change accounting policies. An example can be changing the inventory valuation method from last in, first out (LIFO) to first in, first out (FIFO). Companies are allowed to adopt standards prospectively (in the future) or retrospectively.

  • Retrospective application means that the financial statements for previous years are presented as if the newly adopted accounting principle had been used throughout the period. A change in accounting policy is applied retrospectively. For example, if a company shifts from LIFO valuation method to FIFO valuation method, this change will require a retrospective application.
  • Prospective application means that only the financial statements for the period of change and for future periods are changed. Financial statements for previous years are not changed. At times, new standards might require companies to change accounting estimates such as the useful life of a depreciable asset. Changes in accounting estimates are applied prospectively.
  • Correction of an error for a prior period is another possible adjustment which requires a restatement of the four major financial statements. If a company is making corrections very often, this gives a negative signal and investors will avoid investing in such a company.

Modified retrospective approach: According to new revenue recognition standards, companies can also use “modified retrospective” method of adoption. Under this approach, companies can adjust opening balances of retained earnings (and other applicable accounts) for the cumulative impact of the new standard. They are not required to revise previously reported financial statements.

5.4.     Non-Operating Items

Non-operating items are typically reported separately from operating income because they are material and/or relevant to the understanding of the company’s financial performance.

Under IFRS, there is no definition of operating activities and companies need to use judgment about which items can be classified as operating and non-operating.

Under US GAAP, operating activities generally involve producing and delivering goods and providing services. All other transactions and events are defined as investing or financing activities. For example, interest expense would be an operating item for a bank but would be non-operating for a manufacturing firm.

In practice, investing and financing activities may be disclosed on a net basis. For example, a manufacturing firm may report net interest expense (interest expense minus interest revenue) in its income statement. The footnotes to the financial statements can provide further disclosure about the net interest expense. The figure below shows a visual depiction of an income statement for a manufacturing firm following US GAAP.

Revenue or Income
Operating Expenses

Cost of Goods Sold

SG&A

Depreciation

Unusual or Infrequent Items

Operating Income
Non-Operating Expenses

Interest Expense

Extraordinary Items

EBT (continuing operations)
Taxes
NI (continuing operations)
Earnings from discontinued operations net of taxes
Net Earnings or Net Income


FRA Understanding Income Statements Part 2