GODFREY HODGSON HOLMES TARCA
CHAPTER 10
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 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
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
Expenses defined
• To make a definition of expenses operational,
it must be associated with a physical activity of the entity - something it does
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
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 recognition
• The recognition criteria for expenses are
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
Expense recognition
• The decrease in future economic benefits
relates to a decrease in an asset or an increase in a liability
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
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
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
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
Allocation of expenses
• In practice, matching is
– very difficult to do
Allocation of expenses
• Three basic methods of matching
– associating cause and effect
Associating cause and effect
• The ideal way of matching is by associating
cause with effect
• Cause and effect relationships are very difficult
to prove
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
Immediate recognition
• Used if neither of the previous two can be
used
• Recognise the outlay immediately as an
expense
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
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
Criticisms of allocations
• The allocation problem
– Thomas – allocations in accounting do not meet the following criteria
• additivity
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
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
Criticisms of allocations
• Alternative approaches suggested
– exit price accounting
Defence of allocations
• Change the objective of allocations
• Continue with allocations only if the benefits
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
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
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
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
