After reading this chapter, you should have an appreciation of the following: HD the nature of expe cin the accounting literature By recognition cite e way they are de ‘oncept as they are applied to expenses in the Hy ctcisms of the matching process and accountants’ use of allocations By chattenges for standard seters and isues for auditors relating to expense recognition and Dipindai dengan CamScanner0 cerute-generating activities which may gig mount of expense 0 be recorded in ay fleets a firm's reported financial positon Business entities engage in a range of tev tise to expenses. Determining the correct iod is very important, as it accounting period is very important, a ‘op and Frat performance, However, calculating the amount of expense and when it shoutg he recognised ig not a straightforward process. In the frst section. of this chapter, yp explore the nature of expenses and the definitions presented in the literature, We discus, scuudard setters’ definitions of expenses ancl explain the relationship of expenses ang Jowses, Expenses represent either an increase in Tiabilities or a decrease in assets, with subsequent effect on equity. We explain how this definition is applied in practice ang discuss the behavioural view of expen: i Recognition criteria for expenses are fundamental to accounting practice. tn the second section of the chapter, we discuss guidance provided in the IASB/AAsp Framework and accounting standards for recognition and measurement of expenses We explore how expenses are determined using the matching approach. Methods of allocating expenses (associating cause and effect, systematic and rational allocation, ‘and immediate recognition) are outlined. Existing practices, such as matching and conservatism, give rise to issues for accounting standard setters and auditors. We discuss current issues for standard setters and auditors in the final two sections of the chapter. EXPENSES DEFINED ‘The discussion of assets, liabilitics and equity, and revenue (chapters 7, 8 and 9) provides some background for us to understand the nature of expenses. We know that an expense has to do with a decrease in value of the firm. Expenses arising in the couse of the ordinary activities include, for example, cost of sales, wages and depreciation. ‘They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, and property, plant and equipment (Framework, para. 78) In the Framework paragraph 70, expenses are defined as follows: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreas equity, other than those relating to distributions to equity participants. Expenses encompass losses as well as expenses which arise in the course of ordinary activities of the entity. Losses may or may not atise in the course of ordinatY activities of the entity, However, the Framework states that losses represent decte3s® in economic benefits and are therefore not different in nature from other expenses Therefore, they are not regarded as a separate clement (para. 79). Firms have sought to distinguish between expenses and losses occurring within and outside ordina activities by categorising items as abnormal or extraordinary in the income statement This practice is not permitted under IAS 1/AASB 101 Presentation of Financial State Paragraph 85 states that an entity must not present any items of income or expe" Dees inary items, emphasising the Framework’s all-encompassing definition The view represented in the LASB/AASB Framework differs from that promulgated bY the Financial Accounting Standards Board (FASB), the US standard setter, COM Statement No. 6 (Paragraphs 68-9) distinguishes between expenses and losses: latter are decreases in net assets from ‘peripheral or incidental transactions’ and £2 PART 2 Theory and accounting practice Dipindai dengan CamScannerOther events that may be largely beyond the control of the firm. Expenses pertain to the ongoing major or central operations. It is interesting to note the point made by Henderson, Peirson and Brown concerning this dichotomy: ‘The FASE distinction between expenses and losses does not seem to be very useful. It Fequites a judgment about whether a transaction is part of the entity's ‘ongoing major or Cental operations’. Not having to distinguish between expenses and losses has distinct advantages... management will no longer be able to decide that an outflow of assets is a loss and omit it from the determination of operating profit.! The differences between the FASB and IASB frameworks will be the subject of discussion as the boards seek to converge their frameworks and standards, Substantial revisions and extensions to the IASB Framework are underway. Changes in assets and liabilities As discussed in chapters 7 and 8, revenues and expenses are directly related to the value aspects of assets and liabilities. By their nature, revenues and expenses come about because of events (namely, increases in the value of liabilities or decreases in the value of assets) in the operation of the business. In reality, the events increasing assets and decreasing liabilities may be difficult to observe. What makes a definition of expenses operational is the concept of physical flows involving the entity, thus the Framework definition refers to outflows or depletions of assets or incurrences of liabilities. ‘The Framework’s definition makes no reference to the relationship of expenses to revenue, although both are defined in terms of future economic benefits. 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 to correlate expenses with the using up of goods or services in support of those events, rather than with those events themselves. The definitions in the Framework all revolve around future economic benefits, thus ensuring their consistency, using the definition of assets as the point of reference. Case study 10.1 explores issues relating to carbon emissions and considers whether inflows or outflows of economic benefits are expected under trading schemes. Expenses and ‘costs’ ‘The Framework implies that the using up of assets entails a cost to the entity, This is in accord with the previous argument that expenses represent a value change. The value change refers to the sacrifice which the firm must make in acquiring the services. Ifthere is no cost to the firm, then there is no expense. For example, if an employee renders services without pay, pethaps in order to gain experience, certainly the company should not record a wages expense. If a machine is donated to a firm and even though the Jsvet would be stated at fair value, it would be theoretically incorrect, under historical ost accounting, for the firm to record depreciation. Sometimes an expense is referred fo as an ‘expited cost’ For example, a special committee of the American Accounting Raociation (AAA) in 1957 presented the following definition: Expense is the expired cost, directly or indirectly to a given fiscal period, of the flow of goods or services into the market and of related operations? CHAPTER 10 Expenses 331) Dipindai dengan CamScanner[a EXPENSE RECOGNITION Once we have determined if an outflow is an expense to the firm, the next se ia to decide when it should be recognised. The Framework specifies two criteria for the recognition of expenses in paragraph 83: An item that meets the definition of an element should be recognised if (a) itis probable that any future economic benefit associated with the item will flow to or from the entity; and ae (b) the item has a cost or value that can be measured with reliability. For an expense to be recognised in the financial statements, it must meet both of the recognition criteria, Firstly, it must be ‘probable’ that the outflow of future economic benefits has occurred. The Framework states that the concept of probability is in keeping with the uncertainty that characterises the environment in which an entity operates. Assessments of the degree of uncertainty attached to the flow of future economic benefits are to be made on the basis of evidence available when the financial statements are prepared (para. 85). If the probability criterion was interpreted as being more or less than 50 per cent, its application could be at odds with the qualitative characteristic of prudence (Framework, para, 37). Prudence is ‘the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated’. Bear in mind that another qualitative characteristic, neutrality, requires the information in financial reports to be free from bias (para. 36). Thus, preparers ideally must exercise caution in their judgements and estimations, but not create a bias in the information reported. For example, the overstatement of expenses reflecting excessive prudence and lack of neutrality would not be acceptable as the information would not be reliable. ‘The second criterion requires that the expense can be ‘measured with reliability’. This Provides for the case where 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, paragraph 31, indicates that information is reliable: when itis free from material error and bias and can be d al er lepended upon by users to represent faithfully that which it either purports to represent or could veaeeiabiy be expected to represent. ‘The Framework indicates that an expense is to be recognised in the incom k statement when a decrease in future economi icbenefits related to a decrease in an asset or an increase depreciation, amortisation or imp: employee benefits gives rise to gai sétters’ point of view, e enue, expenses and shows that accepted Dipindai dengan CamScannerBSE EXPENSE MEASUREMENT the measurement of additions to liabilities and depletion of assets in the current Period may seem a simple task. However, liabilities may increase because of the acquisition in the current period of key operating equipment with an estimated Operating life of many years. Investments may be made in the current period in livestock which will not reach maturity and subsequently generate revenue for a number of years, This means that in measuring expenses in the current period, a number of decisions need to be made as to how expenses should be allocated across future periods of resultant revenue. There are a number of accounting standards that provide guidance on such matters, but offer a choice in the method of expense and Tevenue apportionment. For example, IAS 16/AASB 116 Property, Plant and Equipment allows for the value of a depreciable asset to be measured in a number of ways after recognition (e.g, the cost model or the valuation model) and for several alternative depreciation options (e.g. the straight-line, diminishing value and units of production methods). The decision criteria are meant to be supported by the accrual accounting concept of matching expenses against revenues in the period to which they relate. The complexity of this process and the underlying discretion in adoption of allocation and measurement techniques are key issues for students of accounting and are the focus of this section. Allocation of expenses ‘One approach to measuring expenses is to allocate them to periods to which they relate. The matching concept forms the basis of accrual accounting. The IASB/AASB Framework recognises the matching concept in paragraph 95 which states ‘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’, The matching process involves the simultaneous ot combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the ‘various components of expense making up the cost of sales are recognised at the same time as the income derived from the sale of the goods (para. 95). For many accountants, relating effort (expenses) and accomplishments (revenue) fora ven period is the main function of accounting, However, in practice, proper matching a dificalt task, and involves a great deal of judgement on the part of the accountant. ‘The accountant must jentify which assets have been used up (expired) and the amount that should be writen off against revenue forthe period. Paton and Littleton state: ‘The problem of proper matching of revenue and costs is primarily one of finding re etony bases of association — clues to relationships which unite revenue deductions sath revenue ... Observable physical connections often afford a means of tracing and and Mngt should be emphasised, however, that the esentl tests reasonableness in Feet of al of the pertinent conditions, rather than physical measurement® indeed, the matching concept is of critical importance in historical cost accounting. It “he accountant in deciding which costs should be expensed and matched against aavenue forthe period, and which costs remain unexpired, to be recorded as assets in tre palance sheet. To overcome problems associated with determining and measuring tis io be egesed and Be ed oad ee base methods of matching a lied on. These a commen use a eet «associating aeematic and rational allocation «systema 5 jmmediate recognition guides CHAPTER 10 Expenses. 333 _—_—$—— Dipindai dengan CamScanner“The first is the ideal way of determining an amount of expense, whereas the second and third are alternatives if the first cannot be used. The methods are discussed below, Associating cause and effect ; ‘The ideal way of matching expenses with revenue is by associating cause with effect, Cause-and-effect relationships are difficult to prove. However, based on what appears to be a reasonable observation, accountants decide that certain goods and services used up must have helped in the creation of the revenue for that period. Examples are sales commissions, cost of sales, and salaries and wages. It seems reasonable to assume that the efforts of the sales personnel helped to generate the sales revenue for the current period. Therefore, their efforts, as represented by the commissions paid or payable to them, should be associated with the current revenue. Similarly, the revenue from selling produc is usually related to the cost of those products sold; and the services rendered by employees are assumed to have helped to create the current revenue. Under revenue recognition principles (see chapter 9), there is no cost of sales if there is no revenue. For example, in long-term construction contracts, when the completed contract method (similar to the sales basis) is used, there are no costs of construction (expense) recorded, as long as there is no construction revenue recognised. The costs incurred in the project are placed in an asset account. When the project is completed’ and ‘sold’, only then are the total accumulated costs inthe asset atcouiit transferred to the expense account to be matched against the revenue. The assumption is that at that point the effort represented by the expense helped produce the revenue. If the percentage-of-completion method is used, the actual construction costs incurred for the given period are assumed to have helped in the creation of the current revenue; therefore, an expense is recorded for the amount of the construction costs, In fact, a common technique for ascertaining the ratio of completion is to use the actual construction costs over the total expected construction costs of the project. However, associating cause and effect may be difficult to apply in practice. One reason is that, in practice, the ‘costs attach’ concept is the basis on which the cause-and- effect rule rests. According to Paton and Littleton: Ideally, all costs should be viewed as ultimatel or services rendered. If this conception could accomplishment of the enterprise could be mé aan of ua Sime tn the more typical situation the degree of continuity of assignments, ofalldases of costsincuted, to partcaan pena pee convincing finally — items of product. Not all coats attach inva diego ments and ; ch in a discernible manner, and this fact forces the accountant to fall back i i i upon a time-period as the unit for associating certain expenses with certain revenues.5 sans ly clinging to definite items of goods sold be effectively realised in practice, the net asured in terms of units of output rather However, Paton and Littleton themselves admit that in the typical situation one cannot it that in the find a basis for ‘costs attach’. In effect, accountants do not directly associate costs with revenue, but match costs to intervals of time. An assumption is made that costs assigned to 4 , 3s expenses must therefore have helped to generate the revenue for that period. Critics also point out that the rule of cause and effect implies that a cectain amoutt ; Int of expenses, For example, suppos® ‘oral expenses are $60.00. Let's say that of the total expenses, one-quarter, or $15 000, is for salaries and wages. If we ae cause an effect, we are claiming that salaries and wages, that is, services rendered by employ’ generated one-quarter of the revenue, id oF $25 000. But no account: ke such an assertion, and certainly it cannot be proven, aan : Dipindai dengan CamScannerSystematic and rational allocation Associating cause: alternative isto use a systematic and rationalallo expenses in the and effect cannot be used for all expenses. When it cannot be done, an -ation procedure. The aim is to recognise accounting periods in which the economic benefits associated with these Hems are consumed or expire (Framework, para. 96). The principle of allocating the cost of an asset to current and future periods is well known in accounting, The matching Process begins by Associating expenses to segments of time. When this is accomplished, the amount of expense is assumed to correlate with the revenue for that period. TAS 16/AASB 116 Property, Plant and Equipment defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’ (para. 6). Thus, depreciation expense is a well-known example of the allocation process. But what is depreciation? A typical answer is that it is a procedure whereby cost is allocated in a systematic and rational manner to periods in which the benefits are expected to be Feceived. Indeed, IAS 16/AASB 116 paragraph 60 states that the depreciation method used must reflect the pattem in which an asset's future economic benefits are expected to be consumed. Considering depreciation as an allocation of costs is unsatisfactory for a number of Teasons. It confuses an event with a valuation method. Is depreciation a procedure or is it a real-world event? We said earlier that an expense represents a monetary event caused by a physical event. Depreciation therefore is a phenomenon that occurs, and the expense recorded is the monetary effect. The intermingling of event and measurement method is due to the costs attach theory. In the United States, the Committee on Terminology saw depreciation as ‘exhaustion of usefulness’* Similarly, the term ‘decline in service potential’ of an asset aptly describes depreciation. However, there are others, including economists, who sce depreciation as a decline in the value of an asset, which is not necessarily the same as the position taken by accountants. A decline in value usually means a decrease in the market price. Accountants see long-term non-current assets as ‘bundles of future services’ that become smaller and smaller because of (1) physical factors such as wear and tear through use, and (2) economic factors such as obsolescence. Depreciation is the decrease or decline of that bundle of services. How is that decline to be measured? Accountants have chosen to use cost allocation. A number of different procedures can be derived from the principle but as long as they are rational and systematic they are considered acceptable. Cost allocation is a matching concept which leads to a variety of procedures. For instance, for depreciation we have the straight-line, units-of-production, sum-of-the- years-digits, diminishing-balance and other methods. The idea is to find a particular fnethod that more of less coincides with the pattem of services or benefits provided by the asset to future periods of time. This is no simple task. Because of the inherent difficulties in applying the principle, many firms select allocation methods based on Seasons that have litle to do with the pattem of benefits. In addition, accounting Practice may ignore matching all together, when it suits the preparers of financial statements. For example, prior t0 = ‘many entities opposed the expensing of stock setjons, even though such a procedure aimed to match revenue with expenditure incurred in its production. - ‘One of the weaknesses of cost allocation is that it relies on estimates and assumptions. ye arbitrary. How do we know ahead of time what the benefits or services the asset will be for each future period? How do we objectively select determine the residual value? a which may b rendered by # time horizon oF CHAPTER 10 Epenses 335 Dipindai dengan CamScanner= An example of the arbitrary allocation of a cost based on time was iesueneston of goodwill. Before widespread adoption of IASB standards in 2 pea ari amortised goodwill over 20 years ot less, often on the straight-line bass. Some companies argued that goodwill did not decrease in value, and therefore should not be subject to amortisation. From 1 January 2005, IFRS do not require goodwill to be amortised, thereby avoiding the arbitrary assumptions which were used in the amortisation process. IFRS 3/AASB 3 Business Combinations paragraph 54 states that, after acquisition, goodwill acquired in a business combination will be measured at cost less any impairment losses. Thus, an estimation process to determine goodwill amortisation is no longer necessary. However, it will be necessary for an entity to assess annually the extent, if any, to which goodwill has been impaired (or reduced in value), which is another type of estimation, An area where allocations are currently used is in relation to share-based payments, TERS 2/AASB 2 Share-based Payment requires that companies record an expense in relation to all remuneration given to employees, whether in the form of cash, other assets or equity instruments of the entity. Three forms of share-based payment are identified. These ar 1. equity-settled share-based payments (the entity receives good and services as consideration for its own equity instruments) 2 2. cash-settled share-based payments (the entity acquires good and services by incurring liabilities for amounts based on the value of its own equity instruments) 3. other transactions (the entity receives or acquires good and services and the entity, or the supplier, has the choice of whether the transaction is settled in cash or equity instruments). The goods and services received in a share-based payment transaction must be recognised when they are received (IFRS 2, para. 7). A corresponding increase in equity is recorded for equity-settled plans and an increase in liabilities i Si ened ies is recognised for cash Eavity-settled plans are most commonly observed (e.g. in the United Kirigdom | Aust | not cash-settled). i received in an equity-settled share-based p. Se Dipindai dengan CamScanneri6a Opti eT Brel Ptions deal dwarfs salary of ANZ chief PESTON | y Stuart Washington ANZ chi $2 ar executive John McFarlane’ total pay as shown in yesterday's annual report was fon. But this figure is dwarfed by the $19.7 million gain he received from cashing in options throughout the year. a size of the options payout enjoyed by Mr McFarlane highlights the large gap need accountng treatment and the reality —with $2.1 million shown as et ened arlane’s total pay, in contrast with the $19.7 million benefit he actually |t also flies in the face of suggestions Mr McFarlane did not receive a pay rise, despite his Teported total pay increasing by less than 1 per cent on last year’s figure. To ANZ's credit — unlike many of its peers in the ASX 50 — the gain on the options transactions is reasonably clearly outlined in the annual report. Yet ANZ still falls short of US disclosure practices by failing to show a year-end price for another 1 million vested ‘options (which means Mr McFarlane can cash them in ‘whenever he chooses). These were worth another $10.1 million to Mr McFarlane as of September 30. On the same date, the bank boss held just over 2 million ANZ shares worth $55.7 million. The Sydney Morning Herald has previously highlighted the lack of meaningful disclosure in many annual reports of large options transactions by chief executives in Australia’s largest companies. In some cases, including McFarlane’s, the deals more than double executives’ reported pay totals. In particular, established chief executives in reasonably successful companies appear to enjoy a late-career benefit of a series of successive share-ownership plans that result in large payouts. Mr McFarlane has been CEO since October 1997, with his extended contract coming to an end in September next year. ‘On Monday the Herald revealed Westpac chief executive David Morgan received a $3.8 million cash payment when he exercised 250,000 “stock appreciation rights” from a 1997 Share plan. The gain on this transaction was not disclosed in the annual report, nor was it disclosed to the stock exchange. “This was on top of a $6.3 million gain Mr Morgan received from exercising options. Again, the ghare-based payments dwarf his reported $8.4 milion pay figure. in Mr McFarlane’ case he exercised 2 million options which met the performance hurdles of ANZ beating the ASX 200 banks index and beating the ASX 100 index, since eaisako eligible for 175.000 performance shares. nay Moning Hea, ¥5 November 2006, wwsinh comau, Source: 5) Questo bos, IFRS 2/AASB 2 requires companies to record an expense in relation to stock Fn te plain the requirements of IFRS 2/AASB 2 and how they differ to previous options pla aden wll need consult adtonal resources. See the ist atthe end of requirements. wis chapter erview of the advantages and disadvantages of the requirements of IFRS 2/ ov AASB 2 5, The article state their company’s restates that certain executives gait much more on options plans than i shown in that nts. For example, the ANZ CEO gained $19.7 m eashing in options, anys ey as $7.2 min the 2006 annuel report. Given tha IFRS 2 requires the but his Pay a ao or share-based payments, explain how ths could occur recording 3 Sawer © question 3, 60 YOU consider that the equtements of IFRS 2 «i eh Dipindai dengan CamScannerU3 Bisa IN ACTION Share option plans worthless by Patrick Durkin Almost three quarters of employee share options pens ee oY ene ean i / th by the law firm De a . vanies since 2003 are now worthless, research by a : ; corey the companies listed in the bottom two-thirds of the S&P/ASK 300 Index, almost 90 per cent of the plans are worthless. Executives at ‘major listed companies including Macquarie Group, Toll Holdings, Tabcorp and Babcock & Brown are just some of those who have watched millions of dollars in share options disappear after the All Ordinaries had its worst calendar year on record in 2008, Jummeting 43 per cent. a , Yesterday, the share market fell to its lowest point this year, with the S&P/ASX 200 Index losing another 5.2% for the year. ; Employee share option schemes have been embraced over recent years, especially by smaller listed companies trying to compete with their higher-paying rivals in the battle for executive talent. The plans set the share price at which executives can take up the options and usually vest three years after being issued. ‘The schemes delivered big windfalls at the height of the boom, with options often being exercised ata fraction of the company’s rising share price. But most of the windfalls executives thought they had pocketed have evaporated Executives at Macquarie Group and Toll Holdings have been hit particularly hard because they are the only two companies in the top 50 which exclusively use option plans, rather than performance rights plans. “Performance rights plans provide at lease some protection from sharp market falls because they have a nil exercise price and the performance hurdle usually involves comparing the company’s total shareholder return against a group of similar companies,” said Andrew Spalding and Shane Bilardi, authors of the research undertaken last month. __ “Provided that the company matches or outperforms its peers, the rights can still vest even in a falling market.” The average exercise price for Macquarie options is $61.23, the company’s most recent annual report shows. At current levels, its share price would need to more than double before the option plans regain any value for executives, Tabcorp options would al: i ibs Pop tld also need to more than double, being on average 54 per cent ott ‘Timbercorp's share price would need to cent out of the money. excl primes ghee P37 ASK op 50 compares hve noe “i seerh most tthe oe ish Scans OF use them in a combination with option plans. increase 13 times, with options on average 92.5 pet Remuneration Strategi their share pri before the crash were cy pees Gary Fi r fre the crash wee imply outdated Y Fitton said that any gearing plans put in p&*° : e adopt a fairly copy Aifere performance hurdles shouldbe wa eon and some investors are now asking WHO given t fs Biven the historically low watermark for the Dipindai dengan CamScanner