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GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 10
EXPENSES

Expenses defined
Expenses
Expenses are
are decreases
decreases in
in economic
economic
benefits
benefits during
during the
the accounting
accounting period
period
in
in the
the form
form of
of outflows
outflows or
or depletions
depletions
of
of assets
assets or
or incurrences
incurrences of
of liabilities
liabilities
that
that result
result in
in decreases
decreases in
in equity,
equity,
other
other than
than those
those relating
relating to
to
distributions
distributions to
to equity
equity participants
participants
(Framework
(Framework para.70)
para.70)
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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
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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
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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
real-world; 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
The IASB is aware of the allocations
setters

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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