1. GODFREY HODGSON HOLMES TARCA
CHAPTER 10
EXPENSES

2. 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)

3. 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

4. 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

5. 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

6. 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

7. Expense recognition
The recognition criteria for expenses are consistent with those of the other accounting elements

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. Allocation of expenses
In practice, matching is
very difficult to do
involves a great deal of judgement
arbitrary

15. Allocation of expenses
Three basic methods of matching
associating cause and effect
systematic and rational allocation
immediate recognition

16. 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

17. 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

18. 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

19. 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

20. 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’

21. Criticisms of allocations
The allocation problem
Thomas – allocations in accounting do not meet the following criteria
additivity
unambiguity
defensibility

22. 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

23. 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 real-world; 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

24. Criticisms of allocations
Alternative approaches suggested
exit price accounting
no allocations

25. Defence of allocations
Change the objective of allocations
Continue with allocations only if the benefits outweigh the costs of doing so

26. 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

27. 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

28. 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

29. Key terms and concepts 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