GODFREY
HODGSON
HOLMES
TARCA
CHAPTER 10
EXPENSES
Expenses defined
• Expenses are decreases in economic benefits
during the accounting period in the form of
outflows or depletions of assets or
incurrences of liabilities that result in
decreases in equity, other than those relating
to distributions to equity participants
• (Framework para.70)
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Expenses defined
• The decrease in value pertains eventually to
the outflow of cash
• Expenses encompass losses as well as
expenses which arise in the course of ordinary
activities
• The distinction between abnormal and
extraordinary items is no longer permitted
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Expenses defined
• To make a definition of expenses operational,
it must be associated with a physical activity
of the entity - something it does
– production and sales generate revenue and the
using up of goods and services in support of those
functions causes expenses to occur
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Changes in assets and liabilities
• Expenses represent a value change
• Framework definition of expenses refers to
outflows or depletions of assets or incurrence
of liabilities
• Framework makes no reference to the
relationship of expenses to revenue
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Expenses and ‘costs’
• Sometimes an expense is referred to as an
‘expired cost’
• The using up of assets entails a cost - expense
- to the entity
• If there is no cost to the firm there is no
expense
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Expense recognition
• The recognition criteria for expenses are
consistent with those of the other accounting
elements
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Expense recognition
• An expense is recognised if
– it is probable that any future economic benefit
associated with the item will flow to or from the
entity; and
– the item has a cost or value that can be measured
with reliability
• prudence and neutrality
• freedom from material error and bias, represent
faithfully
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Expense recognition
• The decrease in future economic benefits
relates to a decrease in an asset or an increase
in a liability
– recognition of an expense occurs simultaneously
with the recognition of an increase in a liability or
a decrease in assets
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Expense measurement
• In measuring expenses a number of decisions
have to be made as to how expenses should
be allocated over periods of resultant revenue
– accrual accounting
– matching expenses against revenues in the period
to which they relate
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Allocation of expenses
• Revenue = accomplishment
• Expenses = effort
• For any given period, matching revenue and
expenses yields net accomplishment (periodic
profit)
• Most of the problems of profit determination
have to do with expense allocation and
matching
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Allocation of expenses
• The accountant must decide
– whether a cost pertains to future revenues and
therefore should be deferred
– whether a cost pertains to current revenues and
therefore should be written-off against that
revenue in the current period
– whether a cost, although incurred and not yet
paid, is related to current revenue and therefore
should be accrued
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Allocation of expenses
• The matching process involves the
simultaneous or combined recognition of
revenues and expenses that result directly and
jointly from the same transactions or other
events
– sales and cost of goods sold
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Allocation of expenses
• In practice, matching is
– very difficult to do
– involves a great deal of judgement
– arbitrary
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Allocation of expenses
• Three basic methods of matching
– associating cause and effect
– systematic and rational allocation
– immediate recognition
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Associating cause and effect
• The ideal way of matching is by associating
cause with effect
• Cause and effect relationships are very
difficult to prove
– reasonable observation
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Systematic and rational
allocation
• An alternative is to use a systematic and
rational allocation procedure
– associate expenses to segments of time
– the expense is assumed to correlate with the
revenue for that period
• depreciation
• Requires estimates and assumptions which
are usually arbitrary
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Immediate recognition
• Used if neither of the previous two can be
used
• Recognise the outlay immediately as an
expense
– advertising expenses
– research expenditure
– impairment expenses
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Criticisms of allocations
• The doctrine of conservatism means that
expenses, losses and liabilities are recognised
as soon possible, even if evidence for them is
weak
• The asymmetrical treatment of revenue and
expenses may create a conservative bias and
misleading financial statements
• Personal incentives may influence managers’
judgement in the allocations process
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Criticisms of allocations
• The allocations (matching) process is an
essential part of accounting practice
• The process has made the balance sheet
secondary to the income statement
• The balance sheet has become a repository
for unexpired costs
• Most of what accountants put in accounting
reports is ‘rubbish’
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Criticisms of allocations
• The allocation problem
– Thomas – allocations in accounting do not meet
the following criteria
• additivity
• unambiguity
• defensibility
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Criticisms of allocations
• Allocations are defended by accountants on
two grounds
– a given input provides services in the current and
future periods and the cost allocation pattern
reflects the cost of the services received in the
given periods
– allocated data serves a useful purpose because
readers of accounting reports, which include
allocated data, find them useful
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Criticisms of allocations
• But, allocations are ‘incorrigible’ - Thomas
– they are not capable of verification or refutation
by objective, empirical means
– the patterns of allocation do not exist in the realworld; they exist only in the minds of accountants
– an input’s individual contribution to the output
cannot be known because all the inputs interact
with each other to generate an output
– empirical studies do not demonstrate that
allocations are useful
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Criticisms of allocations
• Alternative approaches suggested
– exit price accounting
• no allocations
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Defence of allocations
• Change the objective of allocations
• Continue with allocations only if the benefits
outweigh the costs of doing so
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Challenges for accounting
standard setters
• The IASB is aware of the allocations problem
and is tackling it in its current projects
• The plea is for reasonableness or
appropriateness and not for objective
evidence
– contradicts the recognition of revenue
– conservatism
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Issues for auditors
• Auditors face issues surrounding the
distinction between expenses and assets, the
period in which expenses are recognised, and
appropriate measurement of expenses
– big bath and cookie jar accounting
– concepts such as matching and conservatism are
not helpful if they distort information and reduce
its utility
– managers have incentives to distort expenses
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Summary
• The nature of expenses and the way they are defined
• Recognition criteria and the matching concept as
they are applied to expenses in the accrual
accounting system
• Criticisms of the matching process and accountants’
use of allocations
• Challenges for standard setters
• Issues for auditors
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Key terms and concepts
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Expenses
Definitions
Economic benefits
Recognition criteria
Probable and reliable
Expense measurement
Matching
Allocation of expenses
Associating cause and effect
Systematic and rational allocation
Immediate recognition
Criticisms of allocations
Conservatism
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