Intermediate Accounting - Mount Allison University

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Intermediate Accounting
Thomas H. Beechy
Schulich School of Business,
York University
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
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Expense Recognition
Thomas H. Beechy
Schulich School of Business,
York University
CHAPTER
7
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
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Introduction



Cott Corporation is the leading Canadian manufacturer of
private-label soft drinks. In 1994, Cott’s stock price dropped
66% in the course of a year, falling to $16.88 per share in
August of 1994, from a high of $49.50 in October of the
prior year.
One reason for this spectacular drop was criticism in the
financial press of Cott’s financial position, and, in particular,
one of their expense accounting policies.
Policies must be chosen to recognize expenses, and there
are areas where generally accepted accounting principles
allow significant latitude. Accountants and financial
statement users have to be on their toes in this area.
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Expense recognition
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Cost, expenditure, and expense
General recognition criteria
Approaches to expense recognition
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Cost, Expenditure, and Expense
 When we agree to pay out
cash (or other assets) for
goods or services received, we
have incurred a cost.
 When we actually pay the
cash, we have an
expenditure.
 When the benefits of the cost
have been used and we put
that cost (or a portion thereof)
on the income statement, we
have recognized an expense.
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Income
Statement
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

General Recognition Criteria
Recognized items must:
– meet the definition of a financial statement element, and
– have a valid measurement basis and amount.
Financial statement elements are based on future economic
benefits or sacrifices; these must be probable for recognition to
be appropriate.
– Expenses are decreases in economic resources, either by way of
outflows or reductions of assets or incurrences of liabilities, resulting
from an entity’s ordinary revenue generating or service delivery activities.
[CICA 1000.38]

Asset or expense? if the asset recognition criteria are met, an
asset is recorded. If not, an expense is recorded
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
Approaches to Expense Recognition
Definitional approach.
– Expenses are created either
through the reduction of an
asset or the increase in a
liability.

Matching approach.
– The matching principle
requires that once revenues
are determined in conformity
with the revenue principle for
any reporting period, the
expenses incurred in
generating the revenue should
be recognized in that period.
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Deferred credits and deferred
debits should be increasingly
under pressure and should
gradually be disappearing from
the financial statements.
The continued devotion of the
AcSB to the “defer and
amortize” approach to many
costs (and revenues) calls into
question the real impact that the
definitional approach is having.
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Measurement
Recognition is not possible unless
there is a reliable amount to Example: Environmental
liabilities
and clean-up costs
record. When is measurement
an
The extent of restoration varies
issue for expenses?
from province to province, and
 If the expense has to be accrued
is subject to change 
at the revenue recognition point,
prior to settlement, accurate sometimes retroactively  by
legislative action
measurement of the liability, and,
by inference, the expense, is aCICA Handbook, Section 1508,
“Measurement Uncertainty”
major concern.
Another major issue in expense measurement deals with the issue of
inter-period allocation: what amortization policies are appropriate?

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Expense categories
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
Direct expenses are expenses, such
as cost of goods sold, that are
associated directly with revenues.
These expenses are recognized at
the same time as the related
revenues. They can also be called
product costs or project costs.
Indirect costs are expenditures such
as interest costs and administrative
salaries, which are not associated
directly with revenues. These are
often called period costs.
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Specific expense policies

Two specific expenses:
– cost of goods sold and
– amortization.

These are important areas:
– they represent significant
expense categories on many
income statements
– there are potentially material
differences in expense patterns
associated with different
policies.
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Cost of goods sold


Management must choose a cost allocation procedure for
allocating the total cost of goods available for sale during
each period between (1) the cost of goods sold and (2) the
cost of the ending inventory.
Inventory accounting policy determines the flow of costs
through the accounting system, not the flow
of goods physically in and out of a
stockroom. The CICA Handbook states
that,
– The method selected for determining cost should
be one which results in the fairest matching of costs
against revenues regardless of whether or not the method
corresponds to the physical flow of goods. [CICA 3030.09]
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Underlying concepts of cost flow
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Specific cost identification
Average cost
First-in, first-out
Last-in, first-out
Comparison of methods
Other issues in inventory
costing
International perspective
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Underlying concepts of cost flow

Four inventory cost flow methods:
– specific cost identification, average cost, FIFO, and
LIFO  are discussed in this section.

Which cost flow assumption results in the
“fairest” matching?
– The AcSB does not provide guidance in this regard,
but indicates only that the decision depends on the
circumstances of the enterprise and industry.

Each flow assumption has direct impacts on the
income statement and the balance sheet.
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
Specific cost identification
Each item stocked be specifically marked so
that its unit cost can be identified at any time.
– information technology  bar codes and scanners,
point of sale and stockroom data capture  now allows
detailed cost data to be efficiently tracked for thousands
of items.

Automotive dealers use the specific cost
method for two reasons.
– First, the dealer’s specific cost is an important
determinant of the sales price.
– Second, each car is unique, and
the serial number links it to a
specific invoice cost
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

Average cost
The average cost method assumes that the cost of inventory
on hand at the end of a period and the cost of goods sold
during a period is representative of all costs incurred during
the period.
Application depends on the inventory system used;
– some companies determine inventory only
at the end of the period (the periodic system);
– others maintain continuous, or perpetual records.


(Inventory cost + current purchase cost)
Total units on hand
The moving-average method is generally viewed as objective,
consistent, and not subject to easy manipulation.
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

First-in, first-out
The first-in, first-out method treats the first
goods purchased or manufactured as the first units expensed
out on sale or issuance.
Goods sold (or issued) are valued at the oldest unit costs, and
goods remaining in inventory are valued at the most recent
unit cost amounts. There are two common rationalizations for
the use of FIFO:
FIFO approximates the physical flow of merchandise and materials
– generally speaking, items that are purchased first are sold first or
used first in operations.
 Under historical cost accounting, costs should be matched to
revenue in historical sequence  the costs first incurred should be
the first that are matched to revenues.

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
Last-in, first-out
The last-in, first-out method of
inventory costing charges the
cost of the most recently acquired
items to cost of goods sold.
– As a result, the units remaining in
ending inventory are costed at the
oldest unit costs incurred, and
– the units included in cost of goods sold
are costed at the newest unit costs
incurred, the exact opposite of the FIFO cost assumption

It may also be possible to manipulate profits in a LIFO system
if prices have been increasing for a long time and the base
level of inventory is carried at very old, low prices.
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Comparison of methods

The impact that the inventory cost flow
assumption has on the financial statements depends on
whether prices are going up or down.
– In periods of rising prices, FIFO results in higher inventory balances,
lower cost of goods sold, and higher profits.
– LIFO has the opposite effect: lower inventories and lower profits.
Revenue Canada does not allow firms to use LIFO for tax purposes.
– Average cost is always in the middle between FIFO and LIFO  the
middle inventory value, and the middle cost of goods sold figure.
Average cost is allowed for tax purposes, and is likely to result in a
lower taxable income than FIFO if prices are rising; one can suggest
that this may be a major reason for its widespread use in Canada,
although its ease of use in a computer-based inventory system must
certainly be another reason.
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Other issues in inventory costing
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
There is an important issue of determining
which costs to include in inventory and which to
treat as period costs.
There is a great deal of flexibility in the matter,
and it is not unusual for a company to use three
different definitions of inventoriable cost:
– one for internal decision-making
(management accounting),
– another for income tax purposes, and
– yet another for external financial reporting.
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


International perspective
Accounting for inventories, called stocks in the U.K. and in
some other English-speaking countries, is similar throughout
the world, with one exception: the use of LIFO.
LIFO is widely used in the United States (largely because it is
acceptable for U.S. income tax purposes), but is not generally
acceptable in the rest of the world, including Australia,
France, the Netherlands, and the United Kingdom.
The International Accounting Standards Committee attempted
to eliminate LIFO from its list of acceptable inventory
methods, but the U.S. put pressure on the IASC to include
LIFO in its list of acceptable methods, and the IASC retained
LIFO as an alternative.
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Asset amortization

When an expenditure is made, it becomes either an expense
(no future benefit that meets the recognition criteria) or an
asset (recognition criteria are met). But the asset does not
remain on the balance sheet forever, except for land.
– Some assets are expensed in their entirety at the revenue recognition
point  inventory is the best example of this.
– Some are expensed as they are consumed in the earnings process 
supplies, for example.
– Others are used or consumed in the earnings process over a period
of time, and must be amortized, or expensed, gradually.
 depreciation is the term used for amortization of tangible capital
assets (buildings, furniture, and equipment)
 costs of natural resources are subject to depletion
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Nature of amortization

In referring to capital assets, the CICA Handbook states that:


Amortization should be recognized in a rational and systematic
manner appropriate to the nature of the capital asset. [CICA
3060.31]
In the section on research and development costs, the CICA
Handbook states that amortization:
. . .should be charged as an expense on a systematic and rational
basis by reference, where possible, to the sale or use of the
product or process. [CICA 3450.28]
Amortization expense is not recognized for sudden and unexpected
factors, such as damage from natural phenomena, sudden changes in
demand, or radical misuse of assets that impair their revenue-generating
ability. These events trigger a one-time write-down


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Capital assets

Amortization (depreciation) alternatives
–
–
–
–
–

straight-line (SL) method
units of production method
declining balance (DB) method
sum-of-the-years'-digits (SYD) method
Sinking fund amortization methods
Depreciation methods used in practice
– straight-line was used by 85%
– declining balance method was used by 24%
– units of production was used by 22%.
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Amortization (depreciation) alternatives
Sinking fund
present value (or interest) methods.
straight-line
units
of production
(SL) method
method
amortization methods The cost of a capital asset is
[Acquisition
 Residual
cost
value]
presumed [Acquisition
tocost
represent
the
present
declining
balancerate
(DB) method
Amortization
Annual SL
[Acquisition
cost

Residual
value]
Estimated
total
units
ofcash
output
over
Accumulated
value
of
the
stream
of
receipts
per
unit of output
= (SYD)Estimated
amortization
=
sum-of-the-years'-digits
method
useful
life in
years
the amortization]
asset’s
productive
life
Annual DB amortization = generated
Each
DB
rate
by
the
asset.
receipt
consists of interest (return on
Annual SYD amortization =
[Acquisition
investment) and
principal cost 
Amortization
rate
per
unit
output
Residual
value]
ofFraction
Annual amortization =
(amortization
expense
or return
of 
Units produced
during the year
investment).
The calculation
associated with this method is
demonstrated in Chapter 11.
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Depreciation methods used in practice

straight-line was used by 85%
declining balance method was used by 24%
units of production was used by 22%.
Why?
– Industry practice
– Companies are taken with the simplicity of the
straight-line method
– Declining balance methods more common
for assets that run significant risk of technological
obsolescence or
 when repair costs are expected to mount up later in an
asset’s life or
 when they must use a form of declining balance for many
assets for tax reporting

– Units of production is used in the resource industry
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Deferred costs
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Pre-operating costs
Other deferred charges
Research and development costs
Computer software costs
Exploration and development costs
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Pre-operating costs

The CICA’s Emerging Issues Committee:
an established company can defer (and amortize)
expenditures in the pre-operating period to the extent that:




The expenditure is related directly to placing the new business
into service, and
The expenditure is incremental in nature (i.e., a cost that would
not have been incurred in the absence of the new business), and
It is probable that the expenditure is recoverable from the future
operation of the new business.
Once in commercial operation, the pre-operating
expenditures should be amortized; the EIC indicated that
this amortization period should not normally exceed five
years
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Other deferred charges
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The CICA Handbook, in Section 3070, deals with the
disclosure of deferred charges, but recognition
concerns are not discussed
Long-term deferred charges are excluded from current
assets and reported either as a separate category or
under Other Assets on the balance sheet.
In practice, perhaps the most common deferred charges are those
related to obtaining long-term debt: bond discounts, bond issue
costs, and up-front fees paid to secure long-term financing. Costs
related to long-term debt are discussed in Chapter 13. Other
common deferred charges are development costs (dealt with in the
next section) and pre-operating expenditures, discussed
previously.
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
Research and development costs
Section 3450 defines both research and development:
– Research is planned investigation undertaken with the hope of gaining new
scientific or technical knowledge and understanding. Such investigation may or
may not be directed toward a specific practical aim or application.
– Development is the translation of research findings or other knowledge into a
plan or design for new or substantially improved materials, devices, products,
processes, systems, or services prior to the commencement of commercial
productions or use. [CICA 3450.02]
Activities
from
both research and development:
Activities excluded
included in
research:
development:
 Engineering follow-through in an early phase of commercial production.
Testing
in search
for, or evaluation
of, product
or knowledge.
process alternatives.
 Quality
Laboratory
research
at discovery
of new
control
duringaimed
commercial
production,
including routine testing of products.
Design,
construction,
and testing
ofresearch
pre-production
prototypes
and models.
 Troubleshooting
Searching
for applications
of new
findings
or other
knowledge.
in connection
with
breakdowns
during
commercial
production.
Design
ofor
tools,
jigs, alterations
molds,
dies
new
technology
..lines,
 Conceptual
formulation
andand
design
ofinvolving
possible
product
or process
alternatives.
Routine
periodic
to
existing
products,
production
manufacturing
processes, and other ongoing operations, even though such alterations may represent
improvements.
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
Research and development costs
Section 3450 of the CICA Handbook recommends that research
costs should be charged to expense when incurred.
Development costs, however, may be capitalized and amortized
if all of the following criteria are met:
the product or process is clearly defined and the costs attributable
thereto can be identified,
the technical feasibility of the product or process has been established,
the management of the enterprise has indicated its intention to produce
and market, or use, the product or process,
the future market for the product or process is clearly defined or, if it is to
be used internally rather than sold, its usefulness to the enterprise has
been established, and
adequate resources exist, or are expected to be available, to complete
the project. [CICA 3450.21]
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Research and development costs
These apparently iron-clad criteria are almost completely
subject to management determination. If management wishes
to capitalize identifiable development costs for products or
processes that they are undertaking, it will be a brave auditor
who tries to challenge them.
Research and development programs are undertaken by
entities with a clear expectation of future profitable results.
Their future benefits establish them as assets.
When research expense is material, the financial statements
must disclose, either in the income statement or in the notes to
the financial statements, the total research and development
costs included in expense for each period for which an income
statement is presented [CICA 3450.34].
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
Computer software costs
Accounting issues concerning the costs of developing computer
software arise in two different contexts:
– Many companies develop computer software systems for their internal
use, either by developing the software with their own staff or by
contracting with an outside developer. Apply the AcSB’s criteria as
outlined in the previous section
– Other companies develop software as a product, to be sold to outsiders.
– Under the FASB standard, software development costs are expensed as
incurred until all the planning, designing, coding, and testing activities
necessary to establish that the product can be produced to meet its
design specifications are completed, or until a working model of the
software is completed. Subsequent costs for further coding, testing,
debugging, and producing masters of the software product to be
duplicated in producing saleable products are capitalized.
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EXHIBIT 7-2 Disclosure Example – Deferred
Software Development Costs
Newbridge Networks Corporation
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
Note 1 Software Development Costs

– Certain applications and systems software development costs are
capitalized once technological feasibility has been established for
the product, the Company has identified a market for the product
and intends to market the developed product. No other development
costs are capitalized. Such capitalized costs are amortized over the
lesser of the expected life of the related product or three years.
Note 6  Software Development Costs
April 30, 1996 April 30, 1995
Balance, beginning of the year
$ 14,532
$ 11,706
Amount capitalized
10,476
8,575
Amortization
6,723
5,749
Balance, end of the year
18,285
14,532





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Exploration and development costs

Exploration and development (ED) costs are the costs that oil and gas
companies and mining companies incur in exploring and developing their
resource properties.
– Exploration is the process of seeking mineral deposits, while
– Development is the process of turning a found deposit into a productive mine
site or oil field

The accounting for exploration and development costs varies widely.
– One extreme is to treat all ED costs as expenses in the period in which they
are incurred.
– The more common approach is to defer and amortize those costs.


The value of the intangible asset is not the value of the mineral resources;
it is only the cost of getting at them.
Depletion is usually calculated on a unit-of-production basis, using the
estimated reserves as the denominator in the per-unit calculation.
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


Cash flow reporting of capitalized costs
Costs that are accounted for as expenses are included in the cash flow from
operations.
Costs that are accounted for as assets are included in the investing activities
section of the cash flow statement.
Amortization on capitalized assets is deducted in determining net income,
but is removed from cash flow from operations (either by adding it back in
the indirect approach, or leaving it out in the direct approach).

A company that follows a policy of capitalizing as many expenses as
possible will, over time, show a consistently higher cash flow from
operations than one that expenses those costs. While this may not fool a
sophisticated user of the financial statements, management may choose to
follow the capitalize-and-amortize approach consistently in an attempt to
improve cash flow per share calculations (made by some analysts) or to
increase the company’s apparent margin of safety over debt restrictions that
are based on operating cash flow.
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Summary of key points



Entities may have a variety of rationales for their choice of accounting
policies. These relate to enhancing cash flows to the entity or its major
players and may result in income maximization, minimization, etc.
An expenditure may be either an asset or an expense. Items that meet
the recognition criteria for assets are recognized as such; other items
are expensed. The recognition criteria are definition, probability, basis
of measurement, and estimation. Of key importance in establishing an
asset is the presence of future economic benefits, essentially cash
flow. This is the definitional approach to expense recognition.
An expenditure that results in asset recognition simply reorganizes the
asset section of the balance sheet but does not affect net assets,
assets less liabilities. Expense recognition reduces net assets.
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Summary of key points



Expense policy has traditionally been described as a matching
process, where expenses are matched to revenues recognized on the
income statement. Matching resulted in questionable deferred asset
and liability items recognized on the balance sheet; the definitional
approach avoids this, and is preferable.
Measurement of an expense is usually only an issue when the
expense is to be incurred at some future point in time, but must be
accrued in the current period. Expenses may be estimated and the
presence of measurement uncertainty disclosed.
Expenses can be described as direct, that is, associated directly with
revenues, or indirect, that is, not directly associated with revenues.
Direct costs are more likely to be deferred if incurred prior to revenue
recognition, while indirect costs are more likely to be expensed as
incurred.
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


Summary of key points
An important accounting policy decision is the inventory cost flow
assumption, which governs determination of cost of goods sold. Alternatives
are specific identification, LIFO, FIFO, and average cost. Only FIFO and
average cost are in widespread use in Canada.
Another major accounting policy decision is the choice of amortization policy
for capital assets and deferred charges. Alternatives are straight-line, units of
production, declining balance, sum-of-the-years’-digits, and, in certain
industries, sinking fund. Straight-line is the prevalent choice in Canada.
Amortization amounts are profoundly affected by the amortization method
chosen, and also by estimates of residual value and useful life.
Pre-operating costs can be deferred, and later amortized, if certain specific
criteria are met. The criteria include an assessment of whether it is probable
that expenditures will be recovered from future profitable operations; the
asset definition must be met through future cash flow.
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

Summary of key points
All research and most development costs must be expensed as incurred. If
certain specific criteria are met, development costs can be deferred, and
later amortized. Again, the criteria for deferral include an assessment of
future markets, establishing future cash flows.
Costs incurred to develop computer software products to be resold may also
be capitalized, and later amortized, if the product meets certain criteria. The
presence of future markets is critical to substantiating asset value.
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