Financial Reporting and Analysis II
Reading 21. Understanding Income Statements
Learning Outcome Statements
e. describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis;
CFA Curriculum, 2020, Volume 3
Subject 5. Expense Recognition
Expenses incurred to generate revenues must be matched against those revenues in the time periods when the revenues are recognized.
- If the revenues are recognized in the current period, the associated expenses should be recognized in the current period and appear in the income statement.
- If revenues are expected to be recognized in future periods, the associated expenses are capitalized (appearing on the balance sheet of the current period as an asset). When the revenues are recognized in future periods, the asset is converted to expenses in those periods.
The problem of expense recognition is as complex as that of revenue recognition. For costs that are not directly related to revenues, accountants must develop a "rational and systematic" allocation policy that will approximate the matching principle. However, matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.
The Matching of Inventory Costs with Revenues
Please refer to Reading 27 [Inventories] for details.
Some issues in expense recognition:
Account receivables arise from sales to customers who do not immediately pay cash. There are always some customers who cannot or will not pay their debts. The accounts owed by these customers are called uncollected accounts. Therefore, accounts receivables are valued and reported at net realizable value - the net amount expected to be received in cash, which is not necessarily the amount legally receivable. The chief problem in recording uncollectible accounts receivable is establishing the time at which to record the loss.
Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless. No entry is made until a specific account has definitely been established as uncollectible. This method is easy and convenient to apply. However, it usually does not match costs with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.
Advocates of the allowance method believe that bad debt expense should be recorded in the same period as the sale to obtain a proper matching of expenses and revenues and to achieve a proper carrying value for accounts receivable. In practice, the estimate of bad debt is made either on the percentage-of-sales basis (income statement approach) or outstanding-receivables basis (balance sheet approach).
Warranty costs are a classic example of a loss contingency. Although the future cost amount, due date, and customer are not known for certain, a liability is probable and should be recognized if it can be reasonably estimated.
Depreciation and Amortization
Please refer to Reading 29 [Long-Lived Assets] for details.
Financial Analysis Implications
In expense recognition, choice of method (i.e., the depreciation method and the inventory method) as well as estimates (i.e., uncollectible accounts, warranty expenses, assets' useful life, and salvage value) affect a company's reported income. An analyst should identify differences in companies' expense-recognition methods and adjust reported financial statements where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the policies and estimates as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about companies' performances.
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-Product and Period Costs
-Match Expense to revenue
Deferred expenses are an asset because they have already been paid in real terms but not yet in accounting terms. In other words, the company has a chunk of expenses it can recognise in the future without actually having to shell out any more cash.
Warranty provisions create deferred tax assets until such time warranty expenses actually incur, because such provisions are included in the price and are paid to the company in advance of future eventual warranty expenses.
Warranty cost liability