B. Expenses and Losses
1. Expenses involved in primary activities are expenses that are incurred in order to earn normal operating revenues. Under the accrual basis of accounting sales commissions expense should appear on the income statement in the same period that the related sales are reported, regardless of when the commission is actually paid. In the same way, the cost of goods sold is matched with the related sales on the income statement, regardless of when the supplier of the merchandise is paid.
Costs used up (or expiring) in the accounting period shown in the heading of the income statement are also considered to be expenses of that period. For example, the utilities used in a retail store in December should appear on the December income statement, even if the utility's meters are not read until January 1 and the bill is paid on February 1.
The above examples reflect the matching principle and show that under the accrual basis of accounting, expenses on the income statement are likely to be reported at different times than the cash expenditures/disbursements.
It is common for expenses to occur before the company pays for them (e.g., wages earned by employees, employee bonuses and vacations, utilities, and sales commissions). However, some expenses occur after the company has paid for them. For example, let's say a company buys a building on December 31, 2018 for $300,000 (excluding the cost of land). The building is assumed to have a useful life of 30 years. The company paid cash for the building on December 31, 2018 but it will record depreciation expense of $10,000 in each of the years 2019 through 2048.
Cash payments do not always mean that an expense has occurred. For example, a company might pay $20,000 to the bank to reduce its bank loan. This payment will reduce the company's cash and its liability to the bank, but it is not an expense.
Some expenses are matched against sales on the income statement because there is a cause and effect linkage—the sale of the merchandise caused the cost of goods sold and the sales commission expense. Other expenses are not directly linked to sales and as a result they are matched to the accounting period when they are consumed or used—examples include utilities expense, office salaries expense, and depreciation expense. Some expenses such as advertising expense and research and development expense can neither be linked with sales nor a specific accounting period and as a result, they are reported as expenses as soon as they occur.
Here's a Tip
Under the accrual basis of accounting, the cost of goods sold and expenses are matched to sales and/or the accounting period when they are used, not the period in which they are paid.
Companies with products in inventory may find that the net realizable value of the products is less than their cost. Often that requires the company to immediately reduce the cost of its inventory on the balance sheet and increase the cost of goods sold on the current income statement. This in turn reduces the current period's gross profit, net income, and owner's or stockholders' equity.
The income statements or profit and loss statements of merchandisers and manufacturers will use a separate line for the cost of goods sold. The other expenses involved in their primary activities will either be grouped together as operating expenses or subdivided into the categories "selling" and "administrative."
2. Expenses from secondary activities are referred to as nonoperating expenses. For example, interest expense is a nonoperating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling.
3. Losses such as the loss from the sale of long-term assets, or the loss on lawsuits result from a transaction that is outside of a business's primary activities. A loss is reported as the net of two amounts: the amount listed for the item on the company's books (book value) minus the proceeds received from the sale. A loss occurs when the proceeds are less than the book value.
Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from the disposal are $2,800. This is less than the $3,500 amount shown in the company's accounting records. Since this retailer is not in the business of buying and selling cars (the sale of the car is outside of the operating activities of buying and selling clothing), the money received for the car will not be included in sales revenues, and the loss experienced on the sale of the car ($700) will not be included in operating expenses. Instead, the $700 loss will appear in a section on the income statement labeled "nonoperating gains or losses" or "other income or losses". The loss is reported in the time period when the disposal occurs.
4. Impairment losses. Some long-term assets owned by a company will experience a significant decline in value and the assets' book (carrying) values will have to be reduced. The amount of the reduction is known as an impairment loss and will be reported on the company's income statement.
One example of an impairment loss involves the intangible asset known as goodwill. Goodwill arises when a company acquires another company for an amount that is greater than the fair value of the tangible assets acquired. The amount of goodwill is assumed to not decrease in value and therefore is not amortized to expense. However, each year the company must test the value. If the test indicates that an adjustment is necessary, an impairment loss will reduce the book value and will be recorded as a loss on the income statement.
Impairment losses can also occur for tangible assets.
Here's a Tip
The income statement or profit and loss statement shows revenues, expenses, gains, and losses.
The income statement does not show cash receipts and cash disbursements.
Then vs. Now. The income statement covers a past period of time, and the past may or may not be indicative of the future. For example, a company supplying a high-demand fad item for the recent holiday season may have had a great year financially, but if it does not produce a similarly successful item for the next holiday season, it may experience a poor year financially.
Expenses Do Not Equal Economic Reality. Because of the cost principle and inflation, the expenses shown on the income statement reflect old costs. For example, assume that a company is operating a forty-year-old manufacturing plant that had a cost of $400,000. The depreciation expense for this plant may be zero on the current income statement because the plant was depreciated over 30 years. The cost of a new plant might be $4,000,000 today and the depreciation expense on the new plant might be $130,000 per year. The cost principle, however, prohibits showing the depreciation based on the replacement cost of a new plant.
Using Estimates. An accountant is not allowed the luxury of waiting until things are known with certainty. In order to recognize revenues when they are earned, recognize expenses when they are incurred, or match expenses with revenues, accountants must often use estimates. Examples include bad debts expense and depreciation expense.
Missed Opportunities Are Not Reported. Assume that an employee failed to do the routine lubrication of a unique production machine and the machine stopped working. In addition to the cost of the parts and labor to repair the machine, the company missed the opportunity to earn $100,000 of profit because the machine was idle. While the cost of the parts and labor will be reported on the current period's income statement as repairs expense, the lost profit of $100,000 will NOT be reported.
If the broken machine causes huge problems for the company's customers, they may switch suppliers. If that occurs, the company estimates that it will lose the opportunity to earn $1 million in future profits. This $1 million is also an opportunity cost that will NOT be reported as an expense or loss on the current period's income statement.