Accounting for Expenses

Author: Martin, Jim

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Abstract: Next to revenue recognition, accounting for expenses gives accountants more headaches than any
other type of transaction. In 2000, the Public Oversight Board's Panel on Audit Effectiveness Report and
Recommendations found that, among the seven most frequently misstated transactions and accounts,
expenses ranked second behind revenue. Several years ago, this author analyzed common pitfalls in the
revenue area. The author has now analyzed recent SEC Accounting and Auditing Enforcement Releases
(AAER) that deal with expense misstatements. A search of the SEC's database of AAERs issued during the
2000-2007 period identified approximately 185 releases containing instances of expense misstatement.
Auditors can and must improve their ability to detect material misstatements in financial statements. Auditors
must be cognizant of the methods of misstatement, and design their audit programs accordingly. The AICPA's
Audit Risk Alerts are useful in spotlighting potential problems, but the AICPA should consider issuing an SAS
that focuses on expense-transaction auditing problems.
Full text: Headnote
A Risk-Prone Area

Next to revenue recognition, accounting for expenses gives accountants more headaches than any other type
of transaction. In 2000, the Public Oversight Board's Panel on Audit Effectiveness Report and
Recommendations found that, among the seven most frequeny misstated transactions and accounts,
expenses ranked second behind revenue. Several years ago, this author analyzed common pitfalls in die
revenue area ("Auditor Skepticism and Revenue Transactions," The CPA Journal, August 2002). The author
has now analyzed recent SEC Accounting and Auditing Enforcement Releases (AAER) that deal with expense
misstatements. The study is confined to AAERs issued in the 2000-2007 period. A discussion of the techniques
used to misstate expenses can provide lessons to auditors that may prove helpful on future audits.
Nature of Expenses
The Financial Accounting Standards Board's (FASB) Statement of Financial Concepts 6 defines expenses as
follows:
[O]utflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from
delivering or producing goods, rendering services or carrying out other activities that constitute the entity's
ongoing major or central operations.

A profit-oriented entity is in business to generate revenues, and must make sacrifices to do so. When those
sacrifices or costs convey no benefits to future periods, they must be accounted for as expenses. In some
cases, the sacrifice is evidenced by a cash outflow, such as paying the current month's utility bill. In other
cases, the sacrifice consists of a promise to pay for a product or service at some future point in time.
Accountants must analyze the sacrifice and determine whether future periods will benefit as when equipment is
purchased, or whether, as in the case of paying the current month's utility bill, the benefits are used up in the
current accounting period. If the benefits are used up, the sacrifice must be allocated to expense accounts and
matched against revenues to determine the operating profit for the current period. Where the sacrifice entails
future service potential for the company, accountants must measure the portion of the sacrifice that provides
future benefits and defer those amounts to future periods in the form of assets. In many cases, the critical issue
for accountants is to determine how much of the sacrifice should be expensed currently and how much should
be deferred to future periods.
Of course, measuring expenses and assets is not always clear-cut. Widi equipment, one must make estimates
regarding the life of the asset, its salvage value, the appropriate depreciation method, and whether the asset's
carrying value is impaired. A misstep with any of these decisions can cause potential misstatements on the
income statement and balance sheet. Recent AAERs indicate that numerous misstatements are occurring, and
unfortunately, these are often deliberately planned by higher management.
Techniques of Expense Misstatement
A search of the SECs database of AAERs issued during the 2000-2007 period identified approximately 185
releases containing instances of expense misstatement. These are categorized in Exhibit 1 and detailed below.
Improper deferral of expenditures. The review of AAERs indicates that some companies are falling into the
deferral trap. Exhibit 1 shows that almost 30% of the AAERs dealt with improper deferrals. It is only proper to
defer recognition of expenses to future periods when related services or benefits will be received in future
periods. Too many companies are submitting to the temptation to delay recording expenses even though there
are no future benefits to be enjoyed.
The majority of improper deferrals consist of ordinary operating expenses. Controllers and CFOs are keenly
aware of the importance of their operating margins and how closely margin trends are evaluated by securities
analysts. For most companies operating expenses consist of three categories: selling, general and
administrative (G&A), and research and development (R&D). Typically, these expenditures relate to currentperiod operations.
A possible exception is advertising costs that arguably might enhance sales in future periods; however, due to
the uncertainty as to whether and to what degree future-period revenues benefit from current advertising, the
general rule is to expense such costs in the same period the advertisements are run. The AICPA's SOP 93-7
allows companies to defer advertising expenses to future periods in very limited situations where a firm can
demonstrate the following:
* Advertising is incurred for the purpose of obtaining sales to customers who can be shown to have responded
specifically to the advertising.
* Such costs result in probable future economic benefits.
The business must be able to provide persuasive evidence of the future revenue that the advertising costs will
generate. Persuasive evidence consists of verifiable historical patterns of past results from simiar efforts.
Paragraph 48 of SOP 93-7 requires that deferred advertising costs be subjected to a recoverability test on each
balance-sheet date. The carrying value must be compared to the expected future net revenues and, if
necessary, written down to an amount that does not exceed future net revenues. Unless the future revenues
and costs can be objectively estimated, the advertising costs must be expensed immethately.
AAER 1257 discusses an Internet service provider's attempt to expand its customer base by providing millions
of computer disks containing startup software to potential customers. The firm deferred expensing the majority

of these marketing expenditures, which allowed it to turn an operating loss into an operating profit The critical
accounting question was whether the SOP 93-7 requirements for deferral were met. The SEC stated that the
company would have to estimate its future subscriber retention rate, future revenues, and future costs in order
for it to objectively apply the recoverability test Since the company operated in a volatile, developing market that
was subject to unpredictable events, the SEC concluded that reliable forecasts could not be made; thus, the
advertising costs should have been expensed when incurred.

Like advertising, R&D expenditures should normally be expensed as incurred; however, deferrals are
sometimes permitted. FASB Concepts Statement 2 allows R&D costs that have alternative future uses as well
as costs that are incurred beyond the development stage to be capitalized.
AAER 1297 deals with a manufacturer of military light aircraft that attempted to reconfigure a military aircraft,
originally designed for the U.S. Army, for possible export to Taiwan. The firm incurred substantial tooling and
prototype construction costs and capitalized those costs rather than treating them as expenses. The decision to
capitalize was based on three arguments: 1) the endeavor had progressed beyond the R&D stage; 2) the costs
of building the prototype were not R&D because the only change was to modify the outer appearance of an
existing helicopter; and 3) both the tools and prototype had alternate future uses.
The SEC rejected all three arguments. Since none of the aircraft were ever produced, the tooling and prototype
costs must have occurred in the R&D stage. As for the second argument, the work to alter the old version of me
aircraft was more than routine, ongoing efforts to modify an existing product, because the prototype had to be
flight tested to see if it met commercial expectations. Finally, the new prototype had no future alternative use
because it was to be disassembled and analyzed after the test flight
The primary lesson to be drawn from these two AAERs is diat both accountants and auditors must realize that
operating expenditures normally are not deferred to future periods. Accountants should depart from me norm
only after careful analysis of the circumstances. Auditors must view capitalized operating costs as a red flag and
examine the deferral with extreme skepticism. Intuitively, an R&D project that never results in a finished product
must not have exited the R&D stage, and any costs should be expensed. Before accepting the deferral of any
normal operating cost, an auditor must obtain objective, verifiable evidence that GAAP requirements have been
met; namely, that future benefits will result from the deferred costs and can be estimated within a range of
reasonableness. For example, it is possible that advertising deferrals might be supported by contracts or letters
of intent from customers attracted by the advertisements.
Impairments not recognized. Even when costs are properly deferred as assets, one must still be aware of
possible impairments. SFAS 144 mandates that accountants must be alert for conditions which could indicate
that impairments of recorded values have occurred, and describes a two-step process for determining and
measuring the loss. Recent AAERs indicate that failure to record impairment losses is a prevalent problem. This
failure is similar to improper deferrals, because a loss in asset values has occurred yet the overstated values
are carried forward improperly to future periods.

AAER 2578 describes an aerospace/ defense contractor that encountered unfavorable market conditions during
the late 1990s as a glut began to develop in the used aircraft market As used planes were traded in, they had to
be repaired or refurbished, and these costs were capitalized, pushing up me book value of the planes. As the
glut became worse, the book value of tiie assets became impaired The company decided to deal widi the
problem by using acceleration depreciation to lower the excessive carrying values, but the SEC deemed this an
inadequate response, as impairment losses were being deferred improperly. In 2000, a group of outside
auditors reviewed the valuations of the used planes and informed management of a substantial excess of book
values over fair market values. The auditors further criticized the firm's practice of recording losses only when
planes were leased or sold instead of when the planes were returned or repossessed. At the end of 2000, the
company performed an impairment analysis, but adopted an improper pooling approach rather than measure
the loss on a plane-by-plane basis as required by Generally Accepted Accounting Principles (GAAP). This
allowed losses on high-book-value assets to be offset by "cushions" on low-book-value aircraft Although the
company was warned by the auditors that the pooling approach was improper, it rejected an auditor-proposed
adjustment on grounds of immateriality.
While accountants must be wary of adverse economic conditions, asset impairments can also result from
decisions made by management. AAER 1579 describes a national retail drug chain that decided to capitalize
the substantial costs incurred in searching for new store sites. These included legal, architectural, and other
professional fees. At times, management would decide to abandon plans for a particular site, which meant that
the capitalized costs should have been written off in the period that the decision was made. Instead of writing off
the entire cost immediately, however, the company violated GAAP by writing off a fixed portion of n asset each
mondi.
Auditors must be skeptical of asset values, especially with regard to long-term assets where original costs may
become partially or completely impaired SFAS 144 lists several factors, such as changes in the planned use of
the asset or changes in the economic environment, which generally indicate that asset values have become
impaired. In some of the cases depicted by AAERs, auditors detected the overvalued assets and proposed
adjustments, but allowed tiieir clients to forego the adjustments because they were deemed immaterial. In
AAER 2578, a company rejected the proposed auditor adjustment that would have lowered operating income by
7%, a number that many investors would consider material. Even where the quantitative amount of the
adjustment is not large, auditors must consider qualitative factors, such as the effect on operating trends or the
impact on key segments of the company, before passing on the adjustment
Netting and camouflaging expenses. More than 30 of the AAERs involved management efforts to hide
expenses by misclassifying them or by netting them against gains from the sale of assets. While netting does
not change net income, it is useful in manipulating key profit numbers (e.g., gross profit) and in hiding
unfavorable trends, especially with regard to operating expenses. For example, a company that lowers general
and administrative expenses by offsetting them against gains can appear to be tighdy controlling expenses.

AAER 1405 discusses a transaction in which an SEC registrant exchanged a privately held subsidiary for
shares of a publicly held entity. The exchange resulted in a $160 million gain to the registrant which was used to
offset operating expenses. To make matters worse, the company made no disclosure of netting the gain and
expense accounts. The result misled investors into tiiinking tiat the company was keeping a tight lid on
expenses. Because of this tendency to distort operating results, GAAP prohibits netting of revenue and expense
transactions.

The SEC has dubbed a similar approach to expense manipulation as "geography rear- rangement" Under this
approach, compa- nies compute historical ratios of particular expense accounts to some base number, such as
net sales or total operating expenses. Expenses are ttien moved from one line item to anotiier to make it appear
that each account is in line widi prior-year results. The same company that used the netting process described
above used reclassification entries to move millions of dollars between line items on its income statement, mus
covering up unfavorable fluctuations that would draw investor attention. For example, if repair expenses tripled,
this fact could be hidden by reclassifying part of the repairs to other expense accounts.
Sometimes a business may want to control a specific expense account because analysts focus on tiat line item.
For example, an online retailer of luxury goods realized that analysts focused heavily on the company's
customer acquisition costs. The retailer transferred a material amount of marketing expenses which were used
to calculate customer acquisition costs into a depreciation account that had no effect on acquisition costs. In a
similar fashion, transferring non-depreciation expenses into depreciation or amortization accounts can improve
EBITDA numbers, another item that many investors consider important
A company's gross margin is anotiier critical measurement of performance. One company decided that an easy
way to improve its gross margin percentage was to simply transfer part of its cost of goods sold (COGS)
account to an operating expense account. AAER 2475 describes a transfer of millions of dollars from COGS to
R&D expenses for the sole purpose of improving gross profit margins.
The AICPA' s Statement on Auditing Standards (SAS) 106 instructs auditors to verify the chert's assertion of
proper classification and full disclosure of relevant information. Analytical procedures may serve as a starting
point, but auditors must also perform adequate detail testing of proper account classification. Unusual accounts
such as suspense, clearing, and gain or loss accounts must be analyzed carefully to verify that they have not
been used to hide expenses that belong in other parts of the income statement Finally, for clients that export
products, auditore should be aware tiat a so-called marketing expense might be a bribery payment Of the 32
AAERs containing expense misclassifications, 25% involved disguised payments that the SEC considered to be
violations of the Foreign Corrupt Practices Act.
Improper charges to reserve accounts. Several companies violated GAAP by setting up unnecessary reserves
to cover unspecified, general risks and using them to absorb future business expenses. These are often
referred to as "cookie jar" reserves because once a CFO realizes that the target earnings are not going to be
achieved, the income deficiency can be erased by either audiorizing journal entries to transfer reserve amounts
direcdy into income or crediting operating expenses and charging reserve accounts.
GAAP prohibits a business from establishing reserve accounts to cover general, unknown business risks. GAAP

also requires companies to immethately restore the amount reserved into income once it becomes clear that the
reserve is no longer needed. Periodic, systematic charges to reserves are not allowed.
In some of the most flagrant cases, companies designed their earnings strategies around mergers. By engaging
in larger mergers, a business could create larger merger reserves and thereby produce a larger "cookie jar"
from which future earnings could be increased. In AAER 1272, the SEC charged that reserves were being
established to stockpile future income.
How could such schemes get past the auditors? In some cases they didn't In one case, the auditors detected
the scheme and proposed an adjustment to prevent the misstatement; however, when the client balked at
adjusting the books, the auditors determined that earnings were not materially overstated and still rendered an
unqualified opinion. The SEC accused the audit firm of making a faulty judgment on materiality.
AAER 1405 provides two valuable lessons. First when determining materiality, auditors must consider more
than just the amount of the known misstatement, they must estimate the likely misstatement of the account
balance. In short, known errors from sampling tests must be projected to the entire population under
examination. The second lesson, already mentioned, is to avoid making materiality decisions based solely on
quantitative evaluations. The SEC warned that materiality assessments should never be purely mechanical and
that stating materiality in quantitative terms is only the beginning of the analysis, and that all relevant qualitative
factors must be considered.
In other cases, companies realized that the reserve account was no longer needed but would either make
systematic writeoffs to the reserve over a period of years, or delay making the write-off until an opportune time
when an earnings boost was needed. Once a reserve becomes unnecessary or excessive, it must be eliminated
or written down immethately. AAER 1379 discusses the impropriety of making gradual reductions to numerous
reserve accounts by periodically reducing both COGS and operating expenses.
Auditors should view systematic charges to reserve accounts as a red flag, and should ask clients to justify
these charges by providing supporting evidence. In AAER 1379, for example, the company had no
documentation to support the journal entries. In most cases, the client will not be able to justify this clear
departure from GAAP. In one case, the auditor asked for management representations to support the
undocumented journal entries, but this is clearly insufficient evidence. The primary lesson for auditors is that
journal entries, especially diose entered manually or late in the fiscal period widiout documentary support, must
be viewed with extreme skepticism.
Underaccruals of incurred expenses. There are two basic types of expense/liability accruals: those that are
determinable because a transaction or economic event has occurred and those that can only be estimated
because they are contingent upon some future event The first type should be more objectively measurable, yet
the AAERs reveal that misstatements often occur because of such tilings as cutoff errors; however, the
misstatements may be deliberate. The SEC accused one corporation of hiding invoices in desk drawers to avoid
recording the related expense at year-end. Among the many types of expenses that were underaccrued
compensation-related expenses were most common. See Exhibit 2 for examples of expense underaccruals
found in mis study.
Contingent liabilities are much more subjective; therefore, businesses face a higher risk when reporting this type
of obligation. AAER 2625 portrays a national food company that allowed its retail store customers to take
discounts if the retailer would undertake promotion activities such as advertising a product in a grocery
advertisement The company recorded the sale and receivable at the full invoice amount, but also accrued an
estimated amount for the related promotion expense/liability for covering the invoice deduction that would be
granted to the retailer when the promotion activity was undertaken. The company's auditors eventually
discovered an internal memo that indicated the estimation model was deficient leading to material
understatements of promotion expenses. While the auditors' role was not discussed, one wonders why the
underaccrual was not detected earlier. Auditors must approach key accounts whose balances are subjectively

determined with skepticism and obtain an understanding of the model used to estimate the expense. The
model's primary assumptions must be thoroughly tested to verify their reasonableness.
The Red Flags Are There
In some ways, the findings of this review of 185 expense-related AAERs are similar to tiiose in the 2003 study of
revenue-related AAERs. First, many of the AAERs reveal that auditors overlook red flags that signal a higher
probability that something is amiss with the chert's financial statements. Some common red flags that should
put auditors on a higher level of alert are topside adjustments, journal entries with no documentary support,
entries made late in the accounting period and unusual entries such as systematic debits to reserve accounts or
the use of atypical accounts such as contra expense accounts. In particular, topside adjustments are often used
to misstate expenses; AAERs involving Cendant, Nortel, Waste Management, and WorldCom, among others,
illustrate the riskiness of these corporate-level adjustments.
Second, auditors often identify the red flags, yet they fail to react accordingly. In many of the AAERs, the SEC
would cite the auditors for failing to modify the audit program to respond to the known risks. Audit working
papers should include documentation of how the nature, timing, or extent of the audit tests was tailored to
address the identified red flags. In too many cases, auditors simply relied on client representations rather than
perform relevant competent substantive tests.
Third, at least in some of the cases, the auditors identified misstatements and proposed adjustments, yet failed
to require the client to make the adjusting entry. The most common reason for passing on the adjustment was
materiality. Ostensibly, the client would convince the auditor that the misstatement was not material to the
overall earnings results. It appears that auditors are prone to overlook me qualitative aspects of materiality and
pass on adjustments that are not quantitatively material. The SECs Staff Accounting Bulletin (SAB) 100
emphasizes that materiality must be evaluated both quantitatively and qualitatively.
Fourth, many of the audit deficiencies resulted from the auditors' apparent unfamiliarity with GAAP and other
professional standards. Failure to ascertain that GAAP accounting was being followed was a common charge of
the SEC. Auditors must reemphasize the importance of staff familiarity with relevant GAAP/GAAS literature.
Exhibit 3 cites key professional standards that are relevant to the five key areas of expense misstatements.
Auditors can and must improve their ability to detect material misstatements in financial statements. Just like
revenues, expenses are prone to misstatement. Auditors must be cognizant of the methods of misstatement,
and design their audit programs accordingly. The AICPA' s Audit Risk Alerts are useful in spotlighting potential
problems, but the AICPA should consider issuing an SAS that focuses on expense-transaction auditing
problems. An audit guide similar to the one on revenue recognition would be helpful, as would continuing
education courses that address accounting for expenses and related audit problems. Auditors can and must
improve their skills in this troublesome area if they are to meet public expectations.
Sidebar
Sometimes a business may want to control a specific expense account because analysts focus on that line
item.
Sidebar
Auditors should view systematic charges to reserve accounts as a red flag, and should ask clients to justify
these charges by providing supporting evidence.
AuthorAffiliation
Jim Martin, PhD, CPA, is a professor of accounting at the University of Montevallo, Montevallo, Ala.
Subject: Costs; Financial statements; Auditors; CPAs; Statements on auditing standards;
Location: United States--US
Classification: 9190: United States; 4130: Auditing

Publication title: The CPA Journal

Volume: 79
Issue: 1
Pages: 26-31
Number of pages: 6
Publication year: 2009
Publication date: Jan 2009
Section: ACCOUNTING & AUDITING: accounting
Publisher: New York State Society of Certified Public Accountants
Place of publication: New York
Country of publication: United States
Publication subject: Business And Economics--Accounting
ISSN: 07328435
Source type: Scholarly Journals
Language of publication: English
Document type: Feature
Document feature: Tables Illustrations
ProQuest document ID: 212238058
Document URL: http://search.proquest.com/docview/212238058?accountid=17242
Copyright: Copyright New York State Society of Certified Public Accountants Jan 2009
Last updated: 2011-07-20
Database: ABI/INFORM Complete,Accounting & Tax

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