Let's talk now about the expenses piece of the income statement. Again, expenses are decreases in owners' equity from costs that are incurred to generate revenues. When does a company record expenses? Well there are two principles that guide a company in determining when to record expenses on the income statement. One is the matching principle. And the other is the conservatism principle. Briefly, the matching principle tells us that we should record expenses in the same period that we record the revenues that those expenses help us to generate. So pretty simple, match expenses to revenues. The conservatism principle, we would apply if it's difficult to match an expense to a revenue. So an example of when we might use the conservatism principle to recognize expenses, would be when we incur marketing costs. A company might pay a lot of money for marketing costs, and the marketing programs that it gets as a result might help to generate revenues for several years in the future. But it might be difficult to determine how much of the marketing cost is associated with revenues this year, revenues the next year, revenues the next year and revenues the next year. So it's very difficult to use the matching principle to guide us about when to record those marketing cost as expenses. So in that case, the standard setters have decided we should use the conservatism principle and go ahead and record all those marketing costs at the time that they're incurred. Another example of when the conservatism principle might guide us in recording an expense, is that we should record anticipated losses earlier. And defer recording anticipated gains until they're actually realized in a transaction. An example here, if we have a piece of land that sits on the books as an asset, and it suffers a permanent decline in it's value. Then we will go ahead and write the value of that asset down and record a corresponding expense, Using the principle of conservatism. But on the other side of the coin, if the value of the land appreciates, we will defer recording any gain from that appreciation until the land is sold and that gain is actually realized in a transaction. Now again, we must remember the implications of accrual accounting that's the root of the matching principle, recording those expenses. At the same time they help us to generate revenues. Let's look at some examples. How much expense should be recorded in the year ending December 31st? Well, the first example, LL Wholesale buys products costing $3,000, in December. It will eventually sell those products to customers in February. How much expense should be recorded the current year? None. The company has acquired an asset and it's probably paid cash to get that asset. So it has an inventory asset sitting on its books in the asset section of the balance sheet. But it doesn't record that inventory as a cost of goods sold expense until the following February, when it actually sells that inventory to customers. At which time it will match the costs of the inventory that was sold to the revenues that they generated and are recorded in February. Let's take another example, LL Wholesale sells products that cost $4,000 to customers in December. And it charges the customers $6,000, it had previously purchased the products for $4,000 in October. The company must record an expense in December because it's going to record the sales of those products in December. So it needs to match the cost of the inventory sold to the revenues that that inventory generated. So in December it will record a cost of good sold expense of $4,000. So its inventory account on the balance sheet will go down of course, because it no longer has the inventory, and that will be recorded as a cost of goods sold expense on the income statement. Let's try another example. The company paid its landlord $9,000 in December for rent for December, January, and February. How much expense should be recorded? Well, the company pays its landlord, $9,000, so it has a right to use the property for three months, December, January, and February. It will spread that cost over those three months at, let's say, $3000 a month. So how much will it record as an expense in December it will record $3,000 to match the cost of the rent to the revenues that renting that facility help generate during the current month. Next example, the employees of the company will be paid $2,000 in January for work completed in December. The matching principle says, we must match that cost to the revenues they helped us generate. The employees worked in December, so the expense must be recorded in December, to match it with the revenues generated. So we'll record an expense, but we'll also record a liability because the company has the obligation to make payment for that in January. But the expense piece on the income statement must be recorded in December to match it with the revenues that these employees helped to generate in December. Another couple of examples. In January, the company obtains a two year loan from the bank for $10,000. The annual interest rate on the loan is 10%. Interest gets paid at the end of the two year period. When should we record an expense related to the interest? Now recall, we didn't record a liability for interest in January when we took out the loan. We said a liability is not incurred until time passes. So between January and December 31st, the company continues to build up an obligation to pay interest as it's using that $10,000 loan to help it generate revenues. So at the end of the year, December 31st, it clearly has an obligation at that point, to pay a years worth of interest. But does not have to make payment until the end of the second year. However, it must record an expense for a year's worth of interest or 10% times $10,000 or $1,000 as of December 31st. Because that's a cost that was incurred to help generate revenues for the period. So it will record an expense and it will record a corresponding liability at December 31st to capture that $1000. And finally, LL Wholesale bought equipment for $10,000 that it expects to use for 10 years. And it doesn't expect it to have any value left at the end of 10 years. This is a cost that the company has incurred that will generate future economic benefit, so it's an asset, right? So this would go on the ballot sheet as an asset for $10,000. An equipment asset, and the cost of that asset must be matched to the revenues it helps to generate. By recording that cost, taking it off the balance sheet, putting it on the income statement as an expense. How long is it going to generate benefit? For ten years. So that $10,000 cost sitting on the balance sheet, I like to say an asset is just an expense waiting to happen, this is a good example. That $10,000 of assets sitting on the balance sheet must be allocated over the ten years that the company will use it to generate revenues. So for simplicity sake let's take $10,000 divided by ten years. So $1,000 will be recorded as an expense in the first year. 1,000 in the second year, 1,000 in the third year, and eventually after ten years, $10,000 of an expense would have been recorded and the value on the balance sheet would then be down to zero. So on December 31st the company must record a years worth of use of that asset which would be $1,000 as an expense. The accounting term for that is a depreciation expense. Now importantly, depreciation does not mean that the value of the asset is declining. It means that depreciation is a term that indicates that we're allocating costs over a period of time.
