Reading 28.2: Expense Recognition

What is qualifies as an expense?

Costs that either decreases economic benefits such as cash outflows or depletion of assets or the incurrence of liabilities resulting in decreases of equity

When are expenses recognized?

in the period in which the benefits of the expenditure are consumed

recognized when you use up what you paid for, not when you paid for it

Matching Principle in the context of expense recognition

expenses are recognized in the same period as revenues

Capitalization

where costs initially treated as assets and then depreciated or amortized over the asset’s life

Period Costs

expenses that aren’t directly tied to revenue recognition

• administrative costs

How are Period Costs recognized?

they are immediately expensed, exception to the matching principle

What is a conservative expense recognition policy?

Expensing costs sooner rather than later

What is a aggressive expense recognition policy?

expensing costs later rather than sooner

When is it appropriate to capitalize a cost?

if it is expected to provide future economic benefits over multiple accounting periods

When is it appropriate to expense a cost that could be capitalized?

when the economic benefits are highly uncertain or unlikely

At what value is a cost capitalized at?

Fair value + acquisition cost + any costs necessary to prepare the asset for use

What’s depreciated, depletion, and amortization

Depreciated —> tangible assets

Depleted —> natural resources

Amortized —> intangible assets

How is land and certain intangible assets treated and why?

Because land and certain intangible assets have indefinite lives, they are not depreciated

True or False: subsequent related expenditures are immediately expensed

False

subsequent costs on an initial expenditure are capitalized as well because it is assumed these costs will add economic benefit

True or False

Not all subsequent expenditures are capitalized.

True

If subsequent costs only maintain the usefulness of an asset, than they are immediately expensed because they are not adding any economic benefit

Which results in more volatility of earnings? Capitalization or Expensing? Why?

Expensing

There is large cash outlay in the beginning and then none after whereas capitalization results in equal depreciation expenses over the life of the asset

Which results in high assets and equity?

Capitalization or Expensing? Why?

Capitalization

A PP&E account is created which increases assets and then retained earnings are increased as net income is greater

Higher or Lower: Net income in the first year

Capitalization or Expensing? Why?

Capitalization = higher, expensing = lower

only a part of the cost is expensed and the remaining is treated as an asset

expensing results in the cost all being expensed in the first year

Higher or lower: Net income in the later years

Capitalization = lower, expensing = higher

There is no expenses in the later years as all of the costs have been accounted for in the first year

There is always a depreciation expense in all periods of the assets life

Higher or Lower: Income Variability

Capitalization or Expensing? Why?

Capitalization = lower, expensing = higher

Net income drastically different in the first year and then normalizes after

Constant expense when capitalized

Higher or Lower: ROA & ROE in first year

Capitalization or Expensing? Why?

Capitalization = Higher, Expensing = Lower

net income is greater in the first year of capitalization therefore the numerator is bigger

expensing creates a small net income in the first year

Higher or Lower: ROA & ROE all other years

Capitalization or Expensing? Why?

Capitalization = Lower, Expensing = Higher

There are no additional expenses, therefore net income is higher in subsequent years

Constant depreciation expense therefore net income is lower + smaller equity base

Higher or Lower: Debt Ratio and D/E

Capitalization or Expensing? Why?

Capitalization = Lower, Expensing = Higher

expensing immediately reduces net income which reduces the amount of retained earnings and thus equity. a smaller equity base means that debt ratios are greater as there is less equity to spread the debt over

Higher or Lower: CFO

Capitalization or Expensing? Why?

Capitalization = higher, expensing = lower

a depreciation expense is added back to operations as it is a non-cash expense and net income is never initally reduced

there is no non-cash expense when an asset is initially expensed

Higher or Lower: CFI

Capitalization or Expensing? Why?

Capitalization = Lower, Expensing = Higher

there was no investment when something was immediately expensed on the IS

when something is capitalized, there was an investment into PP&E and a line item is added

Capitalized Interest

when a firm constructs an asset for its own use or resale, the interest that accrues from financing the construction is capitalized

With capitalized interest, is the actual asset being financing capitalized too?

Yes, it is adding future economic value

How is capitalized interest depreciated?

COGS ==> if the asset is held for sale

Depreciation Expense ==> if the asset will be used

Where is capitalized interest recorded on the CFS?

Investing activities

Where is interest on debt in the CFS?

CFO

True or False: all companies have to record interest on debt in CFO.

False

If governed by IFRS, interest can be included in CFO or CFI

Should both capitalized interest and interest on debt be used when calculating interest coverage ratios?

yes

Research Costs

costs aimed at the discovery of new scientific or technical knowledge and understanding

Development Costs

translates research finds into a plan or design of a new product

How are Research and Development Costs treated?

Research —> expensed as incurred

Development Costs —> expensed as incurred or capitalized

Under GAAP, how are R&D costs treated?

Both are usually expensed

How are Costs of Creating Software for Sale to Others treated?

expensed as incurred until the product’s technological feasibility has been established, after which the costs of developing a salable product are capitalized

How do analysts compare financial statements that use different methods for R&D expense recognition

Expense all R&D costs

Move all capitalized costs from CFI to CFO

How are Bad Debt Expenses treated?

a firm has to estimate a bad debt expense and recognizes it in the period of the sale