Quilts &Shams Enterprise, Before and After Accounting Period Expenditure - How to Measure Business Expenses

An expense is defined as a decrease in owner’s equity resulting from the operations of the business. To repeat, to give rise to an expense, a transaction must (1) cause a decrease in the owner’s equity and (2) result from operations of the business.

Quilt & Shams Enterprise acquires an asset and pays for it by disbursing cash, by incurring a liability, or by exchanging another asset. The acquisition of an asset does not give rise to an expense because it does not decrease the owner’s equity.

The acquisition of an asset does not give rise to an expense. Such an acquisition is called expenditure. However, the delivery of quilt and shams to a customer costing $200 in gasoline as a result of a sale gives rise to an expense, whereas the purchase of that inventory is expenditure.

Assets are purchased because they are expected to be useful to the operations of the business, an expense is incurred to whatever extent the asset is consumed. Thus an asset gives rise to expenditure when acquired, and to an expense as it is consumed.

Quilts & Shams Enterprise purchases a two-year supply of fuel oil on December 15, 2007, paying $1,000. No fuel oil is used in 2007. Half of it is used in 2008, and half in 2009. When shall there be an expenditure and an expense? There will be expenditure in 2007 and an expense in 2008 and 2009.

Between the time of acquisition and the time of consumption, the resources of a business are assets. Thus the disbursement of funds to purchase fuel oil is termed expenditure; the fuel oil are assets until consumed; when consumed they give rise to an expense.

In the transaction above, the balance sheet item for fuel oil will show the following amounts in the years 2007-2009: As of December 31, 2007. . $1,000; as of December 31, 2008. . $500; as of December 31, 2009. . $0.

To continue, the item “fuel oil expense” on the income statements of Quilts & Shams Enterprise during 2007-2009 will be as follows: For the year 2007. . $0; for the year 2008. . $500; for the year 2009. . $500.

Over the life of the business, most expenditure become expenses, but in a short period of time, there is no necessary correspondence between expenditures and expenses.

A prime example of an asset that becomes an expense when it is used is Quilts & Shams Enterprise’s finished products in a company’s merchandise inventory. When the merchandise is sold, the cost at which it has been carried in inventory is added to the expense category, cost of goods sold, and the inventory account decreases by the same amount.

Quilts & Shams Enterprise produces part or its entire inventory. In such a company, the creation of inventory adds to the asset amount of the business. Between the time of manufacture and sale of a product, manufacturing costs such as wages of production personnel become part of the cost of the product manufactured, and remain as an asset, merchandise inventory, until the product is sold.

For example, if $10 in labor costs is required in order to manufacture a quilt whose material cost is $15, this quilt will be included in the balance sheet inventory item at a cost of $15 until it is sold.

Services and other intangibles purchased prior to the period during which their benefits are received are treated as assets until they are consumed. Insurance protection, prepaid rentals, and prepaid taxes are examples. These items appear as “Prepaid expenses” on the balance sheet.

Quilts & Shams Enterprises purchases a two-year insurance policy on December 31, 2008 for $6,000. The effect of this transaction will show a decrease in cash and an increase in the asset, prepaid expense.

During 2009, the enterprise incurs $3,000 of insurance expense. There is an increase in insurance expense and a decrease in prepaid expenses. A part of the asset is transferred to the expense account after the one year insurance coverage has expired.

Factory buildings, production machinery, etc., which normally have a useful life of several years are called fixed assets. These are also converted into expenses as they are used up.

In the case of fixed assets, it is necessary to estimate the useful life of the asset, and to charge off portions of the cost to expense account to some predetermined plan. This process, which is called depreciation would not normally apply to inventory and would normally apply to a factory building.

So far we have discussed expenditure of Quilts & Shams Enterprise which is made before the accounting period during which the relevant expense is recognized. We discovered that the time at which the expenditure is made does not affect the time at which the expense is recognized, and that the expenditure is treated as an asset until the expense is recognized.

Sometimes the expenditure is made after the accounting period in which the expense is recognized. For example, wages and salaries that are earned in 2009 but paid in 2010 will be recognized in 2009.

When an expense is recognized in an accounting period prior to the relevant expenditures, as in the case of wages earned in 2009 but paid in 2010, the obligation to pay for the goods or services received is shown as a liability until expenditure or cash outlay occurs.

An expense incurred prior to expenditure is added to the expenses of the income statement even though the relevant expenditure has not yet occurred. Another word for added is accrued. For this reason an expense incurred prior to its related expenditure gives rise to a liability entitled “Accrued expense” on the balance sheet until the expenditure is made.

In 2009 an employee earns $5000 that will be paid to him until 2010. To record the effects of this transaction in 2009, we must enter an increase in wages expense and a corresponding increase in the liability, accrued expenses.

In 2010 when the enterprise pays the employee it will record a decrease in cash and a corresponding decrease in the liability, accrued expenses.

I have discussed the case where the cash disbursement precedes the incurring of expenses and the case where it follows the expense. Of course when expenditure falls in the same accounting period as the expense, no problems arise, we merely record the appropriate decrease in cash and increase in expense.

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