In the last post we discussed the problems associated with revenue recognition and how revenue is recognized on the income statement under different scenarios. In this post we move on to discussing the various aspects of expense recognition.
Expense recognition on income statements
Expenses are depletion in assets or increases in liabilities resulting in depletion in equity. On income statements, expenses are deducted from revenue to arrive at net income. Like revenue recognition, expense recognition has its associated problems.
If revenues and expenses were recognized when cash was received or paid there would be no problem. However, under accrual accounting, revenue recognition or expense recognition may or may not be associated with cash transfers. Under accrual accounting, expense incurred for generating revenue has to be recognized in the same period as the revenue. For example, if raw materials purchased in the first quarter of a year is used up in the second quarter of the year to produce finished goods which are sold in the same quarter, the cost of the raw materials can be included in the cost of goods sold only in the second quarter of the year when the goods are sold and not in the first quarter.
Period costs are costs that cannot be directly tied to any revenue. For example, administrative costs. These costs are expensed in the period in which they are incurred.
Inventory expense recognition
There are three methods for valuing inventory, FIFO method, LIFO method and weighted average cost method. We will review each of them one by one.
Under the FIFO method, i.e. First In First Out method, expense recognition criteria states that the cost of inventory of raw materials that is purchased first is included in the cost of goods sold and the inventory purchased later becomes a part of ending inventory balance for the period. That is to say, the inventory that is purchased first is used first for producing the finished goods. This practice is followed more in the case of perishable goods so that the stock of inventory is always fresh.
Under the LIFO method (Last In First Out), as the name suggests expense recognition criteria states that, the inventory that is purchased last becomes a part of cost of goods sold and the inventory that was purchased earlier becomes a part of ending inventory balance for the period. This method is used to value inventories of goods that do not deteriorate with age.
Under the weighted average cost method, the total cost of inventory id divided by the total units of inventory to arrive at the weighted average cost. This cost is applied to both, inventory included in cost of goods sold and ending inventory balance.
LIFO is more popular because of its tax benefits. In an inflationary scenario, cost of inventory last in would be the highest because of the steadily rising prices. Therefore, LIFO method would ensure that the cost of goods sold is high and taxable income is low, leading to lower taxes.
FIFO, LIFO and weighted average cost methods are permitted under both IFRS and GAAP. However, LIFO is not permitted under IFRS.
Depreciation expense recognition
Through depreciation expense the costs of long lived assets are matched with revenues generated from them. Long lived assets are those from which economic benefits accrue beyond one accounting period. According to the depreciation expense recognition principle, costs are appropriated over the asset’s life through depreciation in case of tangible assets and amortization in case of intangible assets.
There are three methods for calculating depreciation expense. The first method is the Straight line method. Under the straight line method, an equal amount of depreciation expense is recognized in each period of the asset’s useful life. Under the straight line method, depreciation is calculated as,
Cost – residual value / useful life
Cost – residual value is the total depreciation in the asset’s value over its useful life which is divided by the no. of years of useful life to get an equal amount of depreciation for each year. In reality assets generate more economic benefits (revenue) in earlier part of their life than in the later part of their life. Using the straight line method, less depreciation is deducted in proportion to the revenue generated in the earlier years of the assets life while more depreciation is deducted in comparison to the revenue in the later years when the revenue generated from the asset is less. This leads to lower net income and higher expenses in the later part of the assets life.
Therefore to better match expenses to revenue, the second depreciation method, i.e. accelerated depreciation method is more useful. Under the accelerated depreciation method, depreciation expense recognition is systematically accelerated to recognize more depreciation in the earlier part of the asset’s life and less depreciation in the later part of its life. Total depreciation under both the straight line method and accelerated depreciation method remains the same.
The third method is the declining balance method, under which a constant rate of depreciation is applied to an assets declining book value each year. Most common declining balance method is the double declining balance method, which applies two times the straight line rate to the declining balance. Depreciation expense is calculated under this method as follows;
2/useful life × (cost – accumulated depreciation)
Depreciation ends once residual value is reached. If the asset is not expected to have any residual value, declining balance method will never fully depreciate it. Therefore, at some point in the asset’s life a switch is made to straight line method of depreciation.
Let’s take an example of double declining balance method. Let’s suppose the asset’s value is $14000 and it is expected to have a residual value of $4000 at the end of 5 years. Therefore depreciation will be calculated as follows;
2/5 × 14000 = 5600
2/5 × (14000 – 5600) = 3360
The accumulated depreciation in the third year will be 5600 + 3360 = 8960
2/5 × (14000 – 8960) = 2016
Since the total accumulated depreciation cannot exceed $10,000 ($14000 – $4000), the depreciation for the third year will be restricted to $10,000 – $8960 = $1040 and not $2016 and with this the asset will be fully depreciated.
Amortization expense recognition
Amortization is the appropriation of cost of an intangible asset over its useful life. In most cases, straight line method is used to calculate amortization expense recognition of an intangible asset with a definite life. It is similar to that used for calculating depreciation in case of tangible assets.
Intangible assets with indefinite lives, like goodwill, trademarks are not amortized. They are however tested for impairment at least annually. If the asset is impaired, impairment expense is recognized on the income statement. Impairment is calculated as;
Carrying value – recoverable value
Bad debt and warranty expense recognition
If a company sells goods on credit or provides warranty, expense recognition criteria says that the company is required to estimate and recognize bad debt and warranty expense in the period of the sale.
Thats all in this post on expense recognition.. I have embedded below a ppt summarising the post for your reference…..to download it just follow the link below the ppt…over the next few posts we’ll discuss the non-recurring items reported on the income statement and earnings per share calculation under different capital structures and Common size income statements….subscribe and stay updated…
For solved examples please refer to the CFA Institute books or any CFA study notes that provide them and you may like to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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