101 Concepts for the Level I Exam
Concept 43: Expense Recognition
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.
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.
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.
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 this 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 this 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 straight line method, where we expense an equal amount of depreciation in each year of the asset’s useful life. The second method is 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) 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.
Implications for financial analysis: Companies disclose their expense recognition policies in the footnotes. An analyst should be able to determine the policies as conservative or aggressive. An aggressive policy would delay the recognition of expenses. An analyst should also determine how difference in policies of two similar companies can impact their financial ratios.