Question

CA2.6 (LO 4) (Expense Recognition Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenues and expenses for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria. Instructions a. Explain the rationale for recognizing costs as expenses at the time of product sale. b. What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain. c. In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense? Explain. d. Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost. Identify the conditions under which it would be appropriate to treat a cost as a loss. e. CATCRA dantod
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Answer 1

(a): The rationale for recognizing costs as expenses at the time of product sale is based on the fact that some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. Expense recognition principle is based on the matching principle and the presumed direct association leads to associating cause and effect. Application of the expense recognition principle is recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of costs that are recognized as expenses at the time of product sale based on the above mentioned rationale are freight out, sales commission etc.

(b): The rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset is based on the fact that their incurrence in a period leads to generation of no discernible benefits in future. Secondly these costs are a measure of assets that has been recorded in previous periods and for which benefits in future cannot be expected.

(c ): The circumstances in which it will be appropriate to treat a cost as an asset instead of as an expense is when it is expected that the asset will produce benefits in future periods and when the cost has led to acquisition of an asset. An appropriate example will be cost of insurance coverage relating to future periods. This will be regarded as a current asset.

(d): When it is not practical or not possible to find a close cause-and-effect relationship between revenue and cost the systematic and rational allocation basis is assumed. In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Examples are depreciation of fixed assets, amortization of intangibles etc.

(e): The condition under which it will be apt to treat a cost as a loss is when there is no resulting revenue. It should be noted that losses result from events that are not anticipated as being necessary and as being integral in the process of generating revenue.