Question

CA2-7 (Expense Recognition Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired.

Instructions

(a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period

.(b) As generally presented in financial statements, the following items or procedures have been criticized as improperly recognizing costs. Briefly discuss each Item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information.

(1) Receiving and handling costs.

(2) Cash discounts on purchases.

Short answer

Three criteria are matching principle, period costs and product costs. Receiving and handling cost and cash discount on purchases are shown in Step 3.

Step-by-step solution

Expense recognition principle

It is a concept of recognizing and reporting expenses when incurred/expensed, irrespective of the effect on cash.

Three criteria to classification of cost

(a) The three criteria that can be used to determine whether such costs should appear as charge in the income statement of the current period are as follows:

1. Matching Principle - The expenses should be properly matched with the revenues. If the connection between revenue and expenses cannot be determined clearly, the expenses will be charged in that current year.

2. Period costs –These are expenses such as administration expenses, officer’s salaries etc., which will be charged in the current period as these are not directly associated with the revenue of that period.

3. Product costs - These are expenses such as material, labour and overhead, which will be charged in the current year if the revenue of the product is associated only with the current year. These expenses are directly linked to revenue.

Receiving and handling cost and Cash discount on

(b) As per matching principle the viewpoints regarding different costs are as follows:

1. Receiving and handling cost

The cost associated with receiving the item and handling are the same. This cost is directly associated with the product, and hence it is a product cost. As per matching principle, the cost should follow the revenue. If the company is expecting the revenue from the product to flow in the future period too, the cost should also be deferred over the accounting periods.

2. Valuation of inventory at the lower of cost or market value

The valuation of closing stock can be done at eithercost or market value, whichever is lower. The cost associated with the inventory is directly linked to the production level. The closing stock of the product will be calculated as follows:

$(\mathbf{Openingstockoftheproduct}\mathbf{+}\mathbf{Purchases}\mathbf{-}\mathbf{SalesoftheProduct})\mathbf{.}$

The benefit/revenue of the products is likely to accruein the future; hence this cost will be reflected as a Current Asset and will be shown in the balance sheet.

3. Cash discounts on purchase

The cash discounts are those discounts which are given to the purchasers of the product by the seller, in order to encourage the purchaser to pay the amount early. These discounts are generally adjusted in the price of the purchases and the net amount (if payable) will be reflected as Current Liabilities in the balance sheet.