Scenic Video Transcript
- Introduction: Expense recognition decisions
- Expense recognition tied to asset decreases: Cash expenses-
- Example 1-Monthly Internet costs paid
- Example 2-Monthly advertising costs paid
- Example 3-Parking ticket received and paid in current month
- Expense recognition tied to asset decreases: Asset usage expenses-
- Example 4-Prepaid insurance usage
- Example 5-Truck usage
- Example 6-Inventory sold
- Expense recognition tied to asset decreases: Asset impairment expense-
- Example 7-Building impaired
- Expense recognition tied to liability increases: Accounts payable accruals expense-
- Example 8-Advertising invoice received
- Expense recognition tied to liability increases: Accrued liabilities expense-
- Example 9-Compensation expense, never invoiced
- Example 10-Cable services, not invoiced before expensed
- Example 11-Parking ticket received (invoiced), but paid in subsequent month
Welcome to the Expense Recognition scenic route video where you're going to learn how to record a wide range of expense recognition entries and importantly how to recognize their similarities and differences. So let's get started.
When should an expense be recognized? Well, remember the definition of an expense. When do events and circumstances that occur in the course of ordinary activities lead to recognizing a decrease in net assets and thus an expense? You might recall from the Owners’ Equity Change Map: assets equal liabilities plus owners’ equity and expenses are going to correspond to negative effects on owners’ equity. Well, how does happen?
And asset goes down, that will lead to an expense or a liability goes up or some combination of these that results in net assets decreasing. How much should be recognized? That is, when and then how much, very similar questions to what we had for revenue recognition except instead of owners’ equity going up, which it was for revenue recognition, now it's going down.
Similar revenue recognition, we're going to look at situations where all of the changes due to either assets or liabilities. In the first situation, assets will go down and will take an expense, but there won't be any effect on liabilities. There could be a combination of these, but we're going to simplify the analysis this way and we're going to handle most all expenses, in fact, even expenses for which both of these are occurring can be broken up in two just to change in assets and change of liabilities by recording a couple of entries rather than one.
And then we're going to look at liability situations where owners’ equity goes down and liability increases, but of course, there's a negative sign on the liability so that's going to result in net assets going down.
So very pure situations, all assets or all liabilities numerous examples, but at the end of the day this one slide has all the basic concepts in it. So as you're going through these examples, be sure to see the similarities. And we're going to help you with that by keeping an update as we go along.
Example 1 – Internet Paid
Here's the first entry in our update, remember, you can have an expense by any asset decreasing or a liability increasing. And we're going to focus from the first several examples on asset decreases and more specifically we're going to look at something called a cash expense and there'll be three examples around cash expenses.
The first example we're going to look at is we're going to pay resource providers in the current period for resources delivered in the current period that have no material future benefits. Now that's a mouthful. So what we're going to do throughout is we're going to look at examples that make this fact pattern very clear.
Here's our first example. Now similar to the revenue recognition entries, the key here is going to be understanding the picture, what happened. Remember when we touched new entries, we said, well there are six steps. But in the long term most challenging is figuring out what happened. Well these pictures are going to be critical for figuring out in all these examples we're going to be looking at what happened.
And now if we look down here, there are four questions. They are absolutely essential. And we're going to be answering those questions. And if you get these questions in this picture, well you won't miss any entries. And that's where all 11 examples and more generally, that's going to be true for all the entries you try to record.
So let's look at what we have here. On October 15th, 2012, Smartgadgets, a retailer that sells cutting edge electronic products pays its internet provider $100 for the right to unlimited internet usage during October. Here's the month of October right here, internet services delivered throughout that month and that's a critical part of our picture. That's the resource we're getting and all benefits are received in that month. Now that doesn't mean strictly all benefits are received, but Smartgadgets’ management concludes that all of the material benefits from using the internet during October will be realized in October, future benefits resulting from October usage well, they’re relatively insignificant.
What's critical in all these examples is understanding how the assumptions map into a picture and then how the picture maps into these four questions. But in the real world, these wouldn't be assumptions, these would be fact patterns in the business context. But in an example, there are assumptions of what the business context looks like.
So how is net assets affected by the payment? Well let's go through our four questions. Should an asset be recognized? Well, I don't think so. It's not clear that the company got a benefit at this date. Should an asset be de-recognized? Absolutely. We're going to have an asset going down for sure. That's $100 of cash going out. Should a liability be recognized? Well, we didn't take on an obligation. We actually paid something.
Should a liability be de-recognized? Well, there was no liability on the books that had to do with this internet provider service. So therefore it’s a zero effect. So we see net assets went down by $100. But when net assets goes down and it's an ordinary activity, well we know how to trace through the OEC map. Owners’ equity went down by $100. Did that have to do with transaction with owners? No. And then did that go into comprehensive income? Of course because it doesn't deal with accounting change and then into net profit and then over here into expenses because this is an expense and then it's an ordinary expense.
Once again we see that the change map helps us but very importantly, we don't start down here at the bottom and work our way up. We start up at the top because expenses are defined in terms of changes of net assets and that's what's going on here. It's internet services helping the company perform.
Now, let's look at the entry. We paid the $100. So we got assets equals owners’ equity. We know that from our prior analysis. We know the asset we have is cash, positively signed account. And let's go look for the expense. We go down to owners’ equity. We look at the net income accounts. And there is advertising expense, the very first expense. Should we take that one? No. Cost of goods sold? No. Compensation expense, well no, we're not compensating employees. Depreciation expense? No, no, no, no, no. Impairment expense? I don't think so. Revenue? Hardly.
So it's one of these two others. I guess its other expense. Yeah, this is not a big deal for this company. So put the account over here as other expense and it's a negatively signed account. Other expense.
Now, I want to go back down here and just see the process I went through because students often have difficulty with this. It's called the process of elimination. We look at all of the accounts that are available and we say, "Well, which one is best?" And after a little bit of experience and certainly after we go through all of the examples here, you're going to know to eliminate many of these accounts and then you're just left with other, some kind of a generic account to use and that happens often.
And then real companies by the way they'll have a chart of accounts and they'll have something down the bottom that looks kind of like miscellaneous or other.
So now, let's continue recording the entry. We know the expense is $100. So cash went down by $100 and expenses went up by $100, but that's a negatively signed account. Why is it a negatively signed account? Because expenses pull down owners’ equity. So there's our mini matrix for this entry.
So what's the journal entry that goes with the mini matrix? Let's look at it: debits and credits. Cash is a debit account, positively signed account on the left-hand side of the equation and it decrease. So that's our credit. So we're going to credit cash for $100 and our debit is the expense. It's a negatively signed account and it's on the right-hand side of the equation and it increased. So we're going to debit other expense for $100. There's your journal entry.
Example 2 – Advertising Paid
What's the next example I'm going to look at? Well, we're still going to be looking at asset decreases. Again, you want to see the similarities and we're going to be looking at cash expenses. Now, the first cash expense was we paid for our benefit where we received all that benefit in that period. Now, we're going to pay resource providers in the current period for resources delivered in the current period that can't be measured reliably enough for asset recognition.
Now this is an important class of expenses. So let's get on with it with an example. Here's example 2, October 15th, 2012, Smartgadgets pays a newspaper $500 for advertising run daily during October. So here we are right here. They're paying for advertising and the advertising is delivered throughout the entire month. So here is the start of the month, the end of the month. So that's the resource we're getting. Smartgadgets’ management believes this advertising will build brand recognition that will increase the sales significantly in October and thereafter.
So from management's perspective, well, they're going to get big future benefits out of this. But the future benefits are not reliably measurable. Standard setters had concluded the future benefits associated with advertising are not reliably measurable at that time the advertisements are run. So this is a judgment made by standard setters. Now, all you folks who are in marketing should say, "Well, that sure looks like an asset to us, we control that brand. We paid for that brand through our advertising expenditures.” All true.
The definition of an asset here arguably is the brand is an asset, but the future benefits can't be measured reliably enough for recognition of an asset on the balance sheet. Now, that means that the accounting is not going to capture the economics very precisely. And that's just the reality of when it's difficult to measure something.
So having drawn our picture and having understood what's going on, let's now go through and answer the four big questions. And again those are the two keys to your success, mapping the business facts into a picture and then taking the picture and simply answering these questions. Should an asset be recognized? Well, we'd like to recognize an asset, but the answer is no. Should an asset be de-recognized? Yes, an asset should be de-recognized because we paid cash. How much cash we paid? $500.
So an asset is going to go down by $500. Should a liability be recognized? No, we didn't take on any obligation. Should the liability be de-recognized? Nope, not at all. So there's no effect here and owners’ equity goes down by $500. We're ready to record the entry. All we got to do is find the accounts. The key to entries is what happened and then figuring out the effect on assets, liabilities, and owners’ equity.
And now, we'll go through the formality of recording the entry. First of all, we know we got owners’ equity and assets. We know we have cash, positively signed account. And we know we have an expense. Now, we've got to go find the expense, advertising expense. First one on the list, minus advertising expense, $500. Cash went down by $500. The expense went up by $500. The equation balances. Everything looks neat.
Now, a couple points here are really important. You see this entry is structurally very, very similar to the entry with internet service provider. The only difference is we picked a different account. But after that well, they look exactly the same. This is a cash expense. I mean we recognized the expense when the cash was paid. In that case it's the same. But economically they're quite different. You see, we got all the benefits from the internet service provider in the month we paid for. And that means the accounting was capturing usage of the assets during that period.
Here, just the opposite is true. We know there's future benefits. We know this advertising is going to help in the future. And we're charging an expense to the income statement and we're saying essentially, well, that's going to take away from our performance, right because income is revenues minus expenses and gains and losses. So we're decreasing our performance measure when in fact the advertising might be quite effective. That's just the consequence of the fact that it's very difficult to reliably measure those future benefits. And the accountant makes a compromise here, they deduct the expense even though there's future benefits. It's really important therefore to realize that though the entry looks structurally the same as the prior entry, well it's not capturing the economics as effectively.
What's the journal entry? Here it is. Here's the debit, credit, and again, it's structurally the same as we had before. We're going to credit cash because it's a debit account, but it decreased. And we're going to debit the expense because we always debit expenses when they increase. So that would be advertising expense. That's your journal entry.
Example 3 – Parking Ticket
Let's look at our update, how are we doing? We're focusing on asset decreases in all these examples. And we're focusing on cash expenses, that is, recognizing an expense when we pay the cash. Three scenarios. Here's the third scenario, we got benefits in both these two scenarios. Now, we're paying a fine. Well, that's not exactly a benefit, or other legal obligations in the current period that arises in the current period. So let's look at the facts. On October 10th, 2012, a Smartgadget's delivery man receives $50 parking ticket that must be paid before the 31st. So the tickets received back here on the 10th of October. On October 20th, Smartgadgets pays the ticket knowing it will pay the ticket in the month that's received and thus before month-end financial reports are prepared, Smartgadgets does not record an entry on October 10th.
Now they could on October 10th record an obligation to make the payment here, an account payable if you will, and then make the payment. But most companies don't do that. If you get billed in the same month you're going to make the payment, well then you just treat this as a cash expense. That's a policy issue by the way. That's not a standard setting issue. From a standard setters’ perspective, the critical thing is that you're going to take the expense in this particular period. So let's look at our four questions over here. Should an asset be recognized? Well, no they sure don't get a benefit when you get a parking ticket. Should an asset be de-recognized? Well, yes because we're going to pay for the ticket. So cash is going down by $50. Should liability be recognized? No. We do have an obligation to pay the ticket, but we're going to meet that obligation within the same month. In fact we're looking at when the ticket was paid and we don't have any obligation going forward.
Now should a liability be de-recognized? Well, we are meeting an obligation, but we didn't record the liability back here, so we don't have one to derecognize. So, no effect on liabilities. And therefore owners’ equity goes down by $50. So what does the entry look like? Cash goes down by $50, same as before. And other expense, why other expense? Well, it's not advertising. It's not cost of goods sold, it's not compensation, it's not depreciation, it's not an impairment. It's other expense.
The entry is, again, structurally identical to the other. We have cash going down and we're taking an expense.
Now, what are the key lessons here? Well these three types of events give rise to cash expenses. Those events are qualitatively different. They represent different things going on in the company. Pay a resource provider in the current period for resources delivered in the current period that have no material future benefits, or insignificant future benefits, that was the internet fee. Pay resource providers in the current period for resources delivered in the current period that can't be measured reliably enough for asset recognition. That was the advertising, remember the brand? Met the definition of an asset, but we couldn't reliably measure when we are going to get the benefits in the future.