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How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy

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9
A UNIQUE EXPENSE:
DEPRECIATION
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58 A unique expense: depreciation
By now you should have a basic sense of accrual - based expense
accounting. Cash outlays for operating a business are not neces-
sarily recorded to expense in the same period the cash disburse-
ment takes place. In other words, expenses are not recorded on a
simple cash basis of accounting, where all a business needs to do is
to keep track of the checks it writes.
Rather, fi nancial statement accounting is concerned with
the correct timing for recording expenses to match expenses
with sales revenue or to match expenses with the correct period
if there is no direct association between a particular expense
and sales revenue. These two guiding principles for recording
expenses are explained briefl y as follows:
Matching Expenses with Sales Revenue: Cost of goods sold
expense, sales commissions expense, and any other expense
directly connected with making particular sales are recorded
in the same period as the sales revenue. This is straightfor-
ward; all direct expenses of making sales should be matched
against sales revenue. You agree, don t you?
Matching Expenses with the Correct Period: Many expenses
are not directly identifi able with particular sales, such as offi ce
employees salaries, rental of warehouse space, computer pro-
cessing and accounting costs, legal and audit fees, interest on
borrowed money, and many more. Nondirect expenses are
just as necessary as direct expenses. But nondirect expenses
cannot be matched with particular sales. Therefore, nondirect
expenses are recorded in the period in which the benefi t to
the business occurs.
Recall that the recording of expenses involves the use of asset
and liability accounts. Chapter 5 explains the use of the inven-
tory account to hold the cost of products that are manufac-
tured or purchased until the goods are sold, at which time cost
of goods expense is recorded. Chapter 7 explains the use of the
accounts payable liability account for unpaid costs that should be
recorded as expenses in the period. Chapter 8 explains the use of
the prepaid expenses asset account to delay recording operating
expenses until the proper time period.
This chapter explains that the costs of the long - lived operat-
ing assets of a business are spread out over their useful lives. The
allocation of the cost of a long - term operating asset to expense is
called depreciation . Please be careful: Many persons think depre-
ciation refers to the loss of value, or decline in market value of an
asset such as a personal automobile. This notion is not entirely
wrong, but in fi nancial statement accounting depreciation means
cost allocation .
Brief Review of Expense Accounting
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