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Say when expenses are recognised and how matching works

CFA® Level I · Financial Statement Analysis · Analyzing Income Statements · FSA.1.c

The idea

Expenses are recognised in the period in which the associated revenue is recognised, which is why cost of goods sold moves with sales rather than with purchases. Costs that cannot be matched to specific revenue are recognised as incurred, and costs that provide benefits over several periods are capitalised and allocated across them. The judgements that matter are the allocation choices: depreciation lives and methods, the estimate of doubtful accounts, warranty provisions and inventory write-downs. Each is defensible within a range, and the position chosen within that range shifts reported profit between periods.

A practice question

From the question bank, with the reason each wrong option is wrong.

Under the matching principle, when is cost of goods sold recognised?

  1. When the inventory is purchasedWhy not: Purchasing converts cash into inventory, an asset. Nothing has been sold, so no cost has been incurred against revenue.
  2. In the period the related revenue is recognised — correct
  3. When the supplier is paidWhy not: Payment settles a payable. Under accruals, when cash moves does not determine when a cost is recognised.

The cost follows the sale, not the purchase or the payment. That is what makes gross profit a meaningful figure for the period.

A harder one

A company lengthens the estimated collection period behind its bad debt allowance. What is the effect?

  1. Higher expense now and lower profitWhy not: The wrong direction. Assuming customers will eventually pay means providing for less, which lowers the expense.
  2. No effect until a receivable is written offWhy not: The allowance is recognised as an expense when it is estimated, not when a specific account is written off. That is the point of having one.
  3. Lower expense now and higher profit, with the shortfall arriving later — correct

The allowance is an estimate of what will not be collected. Reducing it defers recognition rather than improving collection.

The hardest tier

Why do estimates such as the allowance for doubtful accounts warrant particular attention?

  1. Because they are defensible within a range — correct
  2. Because they are not disclosed in the notesWhy not: They are disclosed, often in detail. Visibility is not the problem — the problem is that a range of figures is defensible.
  3. Because they are excluded from the auditWhy not: Estimates are audited, and are usually among the areas auditors flag as requiring most judgement. Judgement audited is still judgement.

There is no single correct allowance. Under-providing raises current profit and creates a future write-off, which is why a falling allowance against rising receivables is a standard warning sign.

In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

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