How to Scan Revenue and Expense Horizons
Recording sales revenue and other income can present some hairy accounting problems. The — accounting rule-making authorities — rank revenue recognition as a major problem area. A good part of the reason for putting revenue recognition high on the list of accounting problems is that many high profile financial accounting frauds have involved recording bogus sales revenue that had no economic reality.
Sales revenue accounting presents challenging problems in some situations. The accounting for many key expenses is equally important. Frankly, it’s damn difficult to measure expenses on a year-by-year basis. Here are a few major expense accounting issues.
Asset impairment write-downs: Inventory shrinkage, bad debts, and depreciation by their very nature are asset write-downs. Other asset write-downs are required when an asset becomes impaired, which means that it has lost some or all of its economic utility to the business and has little or no disposable value. An asset write-down reduces the book value of an asset.
Employee-defined benefits pension plans and other post-retirement benefits: The U.S. accounting rule on this expense is extremely complex. Several key estimates must be made by the business, including, for example, the expected rate of return on the investment portfolio set aside for these future obligations.
This and other estimates affect the amount of expense recorded. In some cases, a business uses an unrealistically high rate of return in order to minimize the amount of this expense. Using unrealistically optimistic rates of investment return is a pernicious problem at the present time.
Certain discretionary operating expenses: Many operating expenses involve timing problems and/or serious estimation problems. Furthermore, some expenses are discretionary in nature, which means how much to spend during the year depends almost entirely on the discretion of managers. Managers can defer or accelerate these expenses in order to manipulate the amount of expense recorded in the period.
For this reason, businesses filing financial reports with the SEC are required to disclose certain of these expenses, such as repairs and maintenance expense, and advertising expense.
Income tax expense: A business can use different accounting methods for some of the expenses reported in its income statement than it uses for calculating its taxable income. Oh, boy! The hypothetical amount of taxable income, as if the accounting methods used in the income statement were used in the tax return, is calculated; then the income tax based on this hypothetical taxable income is figured.
This is the income tax expense reported in the income statement. This amount is reconciled with the actual amount of income tax owed based on the accounting methods used for income tax purposes. A reconciliation of the two different income tax amounts is provided in a technical footnote schedule to the financial statements.
Management stock options: A stock option is a contract between an executive and the business that gives the executive the option to purchase a certain number of the corporation’s capital stock shares at a fixed price (called the exercise or strike price) after certain conditions are satisfied. Usually a stock option does not vest until the executive has been with the business for a certain number of years.
The question is whether the granting of stock options should be recorded as an expense. This issue had been simmering for some time. The U.S. rulemaking body finally issued a pronouncement that requires a value measure be put on stock options when they are issued and that this amount be recorded as an expense.
You could argue that management stock options are simply an arrangement between the stockholders and the privileged few executives of the business, by which the stockholders allow the executives to buy shares at bargain prices. The granting of stock options does not reduce the assets or increase the liabilities of the business; instead, the cost falls on the stockholders.
Allowing executives to buy stock shares at below-market prices increases the number of shares over which profit has to be spread, thus decreasing earnings per share. Stockholders have to decide whether they are willing to do this; the granting of management stock options must be put to a vote by the stockholders.
Please don’t think that the short list above does justice to all the expense accounting problems of businesses. U.S. businesses — large and small, public and private — operate in a highly developed and very sophisticated economy. One result is that expense accounting has become very complicated and confusing.