Expenses: Meaning, Categories and Its Recognition

In this article we will discuss about Expenses:- 1. Meaning of Expenses 2. Categories of Expenses 3. Recognition.

Meaning of Expenses:

Expenses are the monetary amount of resources used up or expended by an entity during a period of time to earn revenues. Expenses are essentially cost incurred in the process of earning revenues through the using or consuming of goods and services.

They are sacrifices involved in carrying out the earning process of a business enterprise during a period. They involve using (sacrificing) goods or services, not acquiring item although acquisitions and use of many goods or services may occur simultaneously or during the same period.

Expenses represent actual or expected cash outflows (or the equivalent) that have occurred or will eventuate as a result of the enterprise’s on-going major or central operations during the period. The expenses may be incurred in one period and payment made in another period. An expense may also represent the cost of using plant or buildings that were purchased earlier for use in operating the business rather than for sale.

As such items are used in operating the business, a portion of their cost becomes expenses, which are known as depreciation expenses. Thus, expenses are measured by the costs of assets consumed or services used during accounting period. Depreciation on plant and equipment, salaries, rent, office expenses, costs of heat, light, power and other utilities, etc., are examples of expenses incurred in producing revenue.

The effects of expenses are gross decrease in assets or gross increase in liabilities relating to producing the revenues. Cash expenditures made to acquire assets do not represent expenses and do not affect owners’ equity. Cash expenditures made to pay liabilities, such as payment of creditors and bank loan, also do not represent expenses and do not affect owners’ equity, i.e., capital.

Similarly owners’ withdrawals, although they reduce owners’ equity, do not represent expenses. Expenses are directly related to the earning of revenue. They are determined by measuring the amount of assets or services consumed or expired during an accounting period.

Expenses and Unexpired Costs:

Expenses are incurred costs associated with the revenue of the period, often directly but frequently indirectly through association with the period to which the revenue has been assigned.

Costs to be associated with future revenue or otherwise to be associated with the future accounting periods are deferred to future periods as unexpired costs (assets). Costs associated with past revenue or otherwise associated with prior periods are adjustment of the expense of those prior periods.

The expenses of a period are:

(a) Costs directly associated with the revenue of the period;

(b) Costs associated with the period on some basis other than a direct relationship with revenue; and

(c) Costs that cannot, as a practical matter, be associated with any other period.

Categories of Expenses:

Important classes of expense are:

(i) Cost of assets used to produce revenue (for example, cost of goods sold, selling and administrative expenses, and interest expenses).

(ii) Expenses from non-reciprocal transfers and casualties (for example, taxes, fires and theft).

(iii) Cost of assets other than products (for example, plant and equipment or investments in other companies) disposed of.

(iv) Costs incurred in unsuccessful efforts.

Expenses do not include repayments of borrowing, expenditures to acquire assets, distributions to owners, or adjustments of expenses of prior periods. Sales discounts and bad debts have been treated conventionally as expenses. Sales returns and allowances are normally treated as revenue offsets.

However, sales discounts do not represent the use of goods or services. If discount is given, the net price represents the price of goods; the discount is a reduction of the revenue and not a cost of borrowing funds. Similarly, bad debt losses do not represent expirations of goods or services, but it simply reduces the amount to be received in exchange for the product.

It should be noted that no priorities need to be given to expenses. The cost of goods sold is an expense just as much as salesmen’s salaries; all expenses are equal in the income determination. Expenses are not recovered in preferential order. There can be no useful income measurement until all expenses have been subtracted from the revenues.

Recognition of Expenses:

In accounting, an expense is incurred when goods or services are consumed or used in the process of obtaining revenue. Recognition of expense may be done at the time of recording activity in accounts or after the activity or before the activity in some situations. The following three principles are important in recognition of expenses that are deducted from revenue to determine the net income or loss of a period.

(1) Matching Process:

Income of an enterprise is assumed to represent the excess of revenue reported during a period over the expenses associated and reported during the same period. Matching is the process of reporting expenses on the basis of a cause-and-effect relationship with reported revenues.

Some costs are recognised as expenses on the basis of a presumed direct association with specific revenue. Recognition of expense through matching process requires:

(i) Association with revenue and

(ii) Reporting in the same period as the related revenue is reported.

Examples of expenses that are recognised by matching process are costs of products sold or services provided and sales commission.

However, there may be situations where expenses may be incurred without generating revenues. For example, advertisement expenses may be incurred although no sales may result. This is the reason that in case no relationship is possible between revenue and expenses incurred, such expenses are classified as indirect or period expenses.

(2) Systematic and Rational Allocation:

In the absence of a direct matching between revenue and expenses, some costs are associated with specific accounting period as expenses on the basis of an attempt to allocate costs in a systematic and rational manner among the periods in which benefits are provided.

The cost of an asset that provides benefits for only one period is recognised as expenses of that period. This may be also termed as systematic and rational allocation.

If an asset provides benefits for several periods, its cost is allocated to the periods in a systematic and rational manner in the absence of a more direct basis for associating cause and effect. The allocation method used should appear reasonable and should be followed systematically.

(3) Immediate Recognition:

Some costs are associated with the current accounting period as expenses because:

(a) Costs incurred during the period provide no discernible future benefits;

(b) Costs recorded as assets in prior periods no longer provide discernible benefits or

(c) Allocating costs either on the basis of association with revenue or among several accounting period is considered to serve no useful purpose.

Application of this principle of expense recognition results in charging many costs to expenses in the period in which they are paid or liabilities to pay them accrue. Examples include officer’s salaries, most selling costs, amounts paid to settle law suits, and costs of resources used in unsuccessful efforts.

The principle of immediate recognition also requires that items carried as assets in prior periods that are discovered to have no discernible future benefit be charged to expenses, for example, a patent that is determined to be worthless.

To apply principles for expenses recognition, costs are analysed to see whether they can be associated with revenue on the basis of matching principles, or systematic and rational allocation or immediate recognition.

Practical measurement difficulties and consistency of treatment over time are important factors in determining the appropriate expenses recognition principle. The guidelines provided for expense recognition give less guidance to the accountant than those provided for revenue recognition and, therefore, are less reliable.

This position is summarised by Jaenicke as follows:

“Revenue recognition principles generally specify how much revenue should be recognised at the same time that they specify when revenue should be recognised, e.g., recognition on the instalment basis defines the amount of revenue recognition each period, i.e., the amount of cash received. Such is not the case with expenses. Principles can specify that the service potential of an asset should be allocated over its future benefit. But unless those principles also provide a means for determining how the asset releases its service potential, they provide little practical guidance.”