CHAPTER 10:

EXPENSE
⦿Business entities engage in a range of
revenue-generating activities which may
give rise to expenses.
⦿Determining the correct amount of
expense to be recorded in an
accounting period is very important, as it
affects a firm’s reported financial
position and performance.
Expenses defined
⦿An expense has to do with a decrease
value of the firm.
⦿Expenses arising in the course of the
ordinary activities include, e.g., cost of
sales, wages and depreciation.
⦿Usually take the form of an outflow or
depletion of assets, such as cash and
cash equivalents, inventory and
property, plant and equipment.
⦿ In the Framework par 70, expenses are
defined:
⦿ Expenses are decreases in economic benefit
during the accounting period in the form of
outflows or depletion of assets or incurrence
of liabilities that result in decreases in equity,
other than those relating to distributions to
equity participants.
⦿ Expenses represent a monetary event
caused by a physical event.
⦿Expenses encompass losses as well as
expenses which arise in the course of
ordinary activities of the entity.
⦿Losses may or may not arise in the course
of ordinary activities of the entity.
⦿Losses represent decreases in economic
benefits are therefore not different in nature
from other expenses. Therefore, they are
not regarded as separate element.
⦿IASB not allow the distinction between
expenses and losses within and outside
ordinary activities.
⦿FASB distinguishes between expenses
and losses 🡪 losses from incidental
activities.
Changes in assets and liabilities
⦿ Revenues and expenses are directly related to the value
aspects of assets and liabilities.
⦿ Revenues and expenses come about because of events
🡪 increases in the value of liabilities or decreases in the
value of assets) in the operation of the business.
⦿ Although revenues and expenses occur as the firm
undertakes the activities that will generate profit, it is
preferable to correlate revenues with the actual
events of production and sale; and correlate
expenses with the using of goods or services in
support of those events, rather than with those events
themselves.
Expenses and Costs
⦿ Using up of assets entails a cost to the entity.
This is in accord to the argument: expenses
represent a value change : the sacrifice
which the firm must take in the services
⦿ If there is no cost to the firm, then there is no
expenses.
⦿ E.g.: if an employee provide service without
payment, so the firm should not record wage
expense; if a machine is donated to the firm,
there is no depreciation expense.
Recognition of Expense
⦿When an outflow should be recognised
as an expense? If it meets two criteria:
⦿1. It is probable that any future
economic benefit associated with the
item will flow to or from the entity; and
⦿2. The item has a cost that can be
measured with reliability.
⦿The concept of probability is in keeping with
the uncertainty that characterises the
environment in which an entity operates.
⦿If the probability criterion was interpreted as
being more or less than 50%, its application
could be at odds (on the contrary ) with the
qualitative characteristics of prudence: that
assets or income are not overstated and
liabilities and expenses are not
understated.
⦿Neutrality characteristic needs
information to be free from bias 🡪
preparers must exercise caution in their
judgements and estimation, but not
create a bias in the information reported.
E.g., overstatement of expenses
reflecting excessive prudence and lack
of neutrality would not be acceptable as
the information would not be reliable.
Second criteria: expense can be measured
with reliability
⦿This provides fro the case that estimates
are required (e.g., depreciation expense,
provision for doubtful debts) but
appropriate evidence to support the
validity of the estimates will be
necessary.
⦿ The framework indicates that an expense is to be
recognised in the income statement when a
decrease in the future economic benefits related
to a decrease in an asset or an increase of a
liability has arisen and can be measured reliably.
⦿ That means that recognition of expenses occurs
simultaneously with the recognition of an increase
in liabilities or a decrease in assets.
⦿ E.g., the change in value of assets give rise the
depreciation, amortisation or impairment expense;
Expense measurement
⦿In measuring the expense of the current
period, a number of decisions need to be
made to as to how expenses should be
allocated across future period of resultant
revenue.
⦿Expenses are recognised in the income
statement on the basis of a direct
association between the costs incurred
and the earning of specific items of
income.
⦿ Relating efforts (expenses) and
accomplishements (revenues) for a given period
is the main function of accounting.
⦿ However, proper matching is a difficult task, and
need a great deal of judgements on the part of
accountant 🡪 they should identify which assets
have been used up (expired) and the amount that
should be written off against revenue for the
period.
⦿ There are three basic method of matching:
⦿ 1. Associating cause and effect🡪 the ideal method
⦿ 2. Systematic and rational allocation
⦿ 3. Immediate recognition
Associating cause and effect
⦿ Itis difficult to prove.
⦿ However, based on what apears to be a
reasonable observation, accountant decide that
certain goods and services used up must have
helped in the creation of the revenue for that
period.
⦿ E.g.: efforts of the sales personnel helped to
generate the sales revenue for the current
period 🡪 their efforts, as represented by the
commissin paid or payable to them, should be
associated to the current revenue
⦿Associating cause and effect may be
difficult to apply in practice.
⦿The reason is that in practice the cost
attach concept is the basis for the cause
and effect rule. But not all cost attach in
a clear manner, and this fact forces
accountant to fall back upon a time-
period as the unit for associating certain
expense to certain revenue.
Systematic and rational allocation
⦿ Associating cause and effect cannot be
done for all expenses 🡪 use systematic
and rational method.
⦿ Aims: to recognise expenses in the
accounting periods in which the economic
benefits associated with these items are
consumed or expire.
⦿ E.g.: the systematic allocation of the
depreciable amount of an asset over its
useful life.
⦿Is depreciation a procedure or it is a real-
world event?
⦿Expense is a monetary event caused by
physical event; but depreciation is a monetary
event caused by phenomenon event.
⦿In US, depreciation is the “exhaustion of
usefulness”; and “decline in service potential”.
⦿Cost allocation is a matching concept that
leads to a variety of procedure.
⦿One of the weakness of cost
allocation 🡪 relies heavily on estimates
and assumptions, which maybe
arbitrary:
⦿How do we know ahead of time that the
benefits or services will be for each
future period?
⦿How do we objectively select a time
horizon or residual value?
Immediate recognition
⦿ One that account for all other possibilities not
covered by the first two principles.
⦿ E.g.: recording the advertising expense.
⦿ The effect of advertising may have long-lasting
benefits, but they are often difficult to determine.
Customers may purchase a product because they
were influenced by an advertisement they saw 2
years ago.
⦿ Another example: - impairment expense,
⦿ - R&D expense 🡪 not meet asset criteria: future
economic benefit are not probable, and can’t be
measured reliably.
Criticisms of Allocations
DEfence of Allocations
Challenge for Accounting Standard
Setters
⦿Matching
⦿Conservatism
Issues for Auditors