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)

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

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

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

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

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

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

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

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 inputs 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

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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