Question

Question: 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

1. Explain the rationale for recognizing costs as expenses at the time of product sale.
2. What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.
3. In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense?
4. 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.
5. Identify the conditions under which it would be appropriate to treat a cost as a loss.

Short answer

The rationale for recognizing cost as expenses at the point of product sale is that the resources are utilized in the similar period in which the sale takes place. Therefore, the production of revenue and the recognition of costs are for the similar period. Part a, b, c, d and e explain in step 2, 3, 4, 5 and 6 respectively.

Step-by-step solution

Meaning of revenue recognition

Revenue recognition is a generally accepted accounting principle (GAAP) that recognizes the particular conditions in which revenue is recognized and ascertains how to clarify it.

Explanation for the statement ‘a’

This is dependent on the matching concept. When revenues are realized at the point of sale, the costs incurred in producing the revenues should also be identified at the similar time so that accurate matching occurs and the net income accurately lists the difference between the revenues and the costs incurred in producing the revenues. For instance, cost of goods sold is listed at the same time when sale is listed.

Explanation for the statement ‘b’

Some costs are allotted as expenses to the existing accounting period because their occurrence during the period gives no noticeable future benefits. Moreover, they are estimates of assets recorded in prior periods from which no future benefits can be anticipated. The amount of cost to be distinguished can be computed only in an unpredictable manner or huge unpredictability exists in relation to the identification of future advantages or both. Therefore, many cost are denoted as “period costs” and are treated as expenses as they have neither a direct association with revenue earned nor can their existence be directly disclosed to produce an asset. For instance, research and development.

Explanation for the statement ‘c’

A cost should be capitalized, that is, treated as an estimate of an asset When it’s anticipated that the asset will generate benefits in later periods. The vital method here is that the undertaking of the cost has led in the acquisition of an asset. If a cost is undertaken that led in the acquisition of an asset from which advantages are not estimated beyond the existing period, the cost may be expensed as a compute of the service capability that expired in generating the existing period’s revenues. Not only should the undertaking of the cost led in the acquisition of an asset from which later benefits are anticipated, but also the cost should be estimable with a reasonable degree of objectivity, and there should be suitable grounds for relating it with the asset obtained.

Explanation for the statement ‘d’

Without the presence of a direct basis for relating asset cost with revenue and if the asset gives benefits for two or more accounting periods, its cost should be assigned to these periods (as an expense) in a systematic and logical manner. Therefore, when it is not possible to ascertain a close cause-and-effect relationship between cost and revenue, this relationship is usually presumed to occur. Thus, the asset cost is assigned to the accounting periods by certain method. The assigning method used should be displayed suitably to an unbiased observer and should be accompanied with uniformly from one period to the other. For instance, amortization of intangibles.

Explanation for the statement ‘e’

A cost should be regarded as a loss when no revenue arises. The matching of losses to particular revenue should not be set out because, they are expired service capability not associated with revenue generated. That is, losses arise from events that are not estimated as mandatory in the method of generating revenue. There is no other method of recognizing a loss because determining whether a cost should be a loss is usually a matter of judgement. The accounting difference between an asset, expense, loss and previous period adjustment is not well defined. For instance, an expense is normally voluntary, anticipated and planned as essential in the production of revenue.