#cfa-level-1 #expense-recognition #reading-25-understanding-income-statement
When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations (i.e., fail to pay). At the time of the sale, it is not known which customer will default. (If it were known that a particular customer would ultimately default, presumably a company would not sell on credit to that customer.) One possible approach to recognizing credit losses on customer receivables would be for the company to wait until such time as a customer defaulted and only then recognize the loss (direct write-off method). Such an approach would usually not be consistent with generally accepted accounting principles.
Under the matching principle, at the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. Companies make such estimates based on previous experience with uncollectible accounts. Such estimates may be expressed as a proportion of the overall amount of sales, the overall amount of receivables, or the amount of receivables overdue by a specific amount of time. The company records its estimate of uncollectible amounts as an expense on the income statement, not as a direct reduction of revenues.
At times, companies offer warranties on the products they sell. If the product proves deficient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product. At the time of sale, the company does not know the amount of future expenses it will incur in connection with its warranties. One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reflect the expense at that time. However, this would not result in a matching of the expense with the associated revenue.
Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty.
Companies commonly incur costs to obtain long-lived assets. Long-lived assets are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance) such as trademarks. The costs of most long-lived assets are allocated over the period of time during which they provide economic benefits. The two main types of long-lived assets whose costs are not allocated over time are land and those intangible assets with indefinite useful lives.
Depreciation is the process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. “Depreciation” is the term commonly applied to this process for physical long-lived assets such as plant and equipment (land is not depreciated), and amortisation is the term commonly applied to this process for intangible long-lived assets with a finite useful life.32 Examples of intangible long-lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life. The term “amortisation” is also commonly applied to the systematic allocation of a premium or discount relative to the face value of a fixed-income security over the life of the security.
IFRS allow two alternative models for valuing property, plant, and equipment: the cost model and the revaluation model.33 Under the cost model, the depreciable amount of that asset (cost less residual value) is allocated on a systematic basis over the remaining useful life of the asset. Under the cost model, the asset is reported at its cost less any accumulated depreciation. Under the revaluation model, the asset is reported at its fair value. The revaluation model is not permitted under US GAAP. Here, we will focus only on the cost model. There are two other differences between IFRS and US GAAP to note: IFRS require each component of an asset to be depreciated separately and US GAAP do not require component depreciation; and IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly require such a review.
The method used to compute depreciation should reflect the pattern over which the economic benefits of the asset are expected to be consumed. IFRS do not prescribe a particular method for computing depreciation but note that several methods are commonly used, such as the straight-line method, diminishing balance method (accelerated depreciation), and the units of production method (depreciation varies depending upon production or usage).
The straight-line method allocates evenly the cost of long-lived assets less estimated residual value over the estimated useful life of an asset. (The term “straight line” derives from the fact that the annual depreciation expense, if represented as a line graph over time, would be a straight line. In addition, a plot of the cost of the asset minus the cumulative amount of annual depreciation expense, if represented as a line graph over time, would be a straight line with a negative downward slope.) Calculating depreciation and amortisation requires two significant estimates: the estimated useful life of an asset and the estimated residual value (also known as “salvage value”) of an asset. Under IFRS, the residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life. Example 9 assumes that an item of equipment is depreciated using the straight-line method and illustrates how the annual depreciation expense varies under different estimates of the useful life and estimated residual value of an asset. As shown, annual depreciation expense is sensitive to both the estimated useful life and to the estimated residual value.