INCONSISTENCIES IN RECOGNITION CRITERIA
Matching is often regarded as the expense recognition principle. Under this principle, we match expenses with associated income for the period to determine the period’s profit or net income. However, the Conceptual Framework for Financial Reporting (2022) (Framework), last revised majorly in 2018, uses a different recognition criterion for expenses. Specifically, only items that meet the definition of income or expenses are recognised in the statement(s) of financial performance (para 5.6). The Framework does not explicitly regard matching as a required principle or a useful concept. Given this stance, should we still attribute the recognition of an expense to the matching principle?
In this article, we review the relevance of the matching principle considering the Framework expositions.
EXPENSE RECOGNITION UNDER THE FRAMEWORK
Under the Framework, items are recognised in the statement(s) of financial position or financial performance only if they meet the definition of one of the elements of financial statements – an asset, a liability, equity, income or expenses (para 5.6). Expenses are defined as “decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims” (para 4.69). For example, expenses are recognised when there is a depletion or impairment of an asset’s potential economic benefits (change in asset). Para 5.5 states that the “initial recognition of assets or liabilities arising from transactions or other events may result in the simultaneous recognition of both income and related expenses”. This simultaneous recognition of income and related expenses is sometimes referred to as the matching of costs with income, or what we commonly refer to in practice as the matching principle. Para 5.5 goes on to add that “matching of costs with income” is not an objective of the Framework and that the Framework does not allow the recognition in the statement of financial position of items that do not meet the definition of an asset, a liability or equity.
The cited paragraphs from the Framework make it clear that matching is not a required recognition criterion. The Framework seems to deemphasise the matching principle and focus more on the recognition of assets and liabilities, and their changes that may simultaneously result in recognition of income and its associated expenses, and hence, their “matching”.
It appears that the intention of the Framework is not to “remove” matching per se but to clarify that matching is not the primary recognition criterion but the proper recognition of assets, liabilities and their changes is. If the latter is done properly, appropriate matching of expenses with associated income will result. This is consistent with the balance sheet or asset-liability approach adopted by the Framework.
Additional evidence to support the above view can be gleaned from the Basis for Conclusions on the Conceptual Framework for Financial Reporting (2022) (Basis). Para BC4.94(c) of the Basis explains that the Board finds it more effective, efficient, and rigorous to define income and expenses as changes in assets and/or liabilities even though the vice-versa approach is possible. The Board adds in para BC4.94(d) that assets and liabilities refer to real economic phenomena and to define them indirectly as changes in matched income and expenses will provide financial statement users with less relevant and understandable information than the adopted approach.
Even though the Board downplays the matching principle and takes a more balance sheet or asset-liability approach in the Framework in para 5.5, the Board did maintain in BC 4.94(a) that it had not designated one type of information – about financial position or financial performance – as the primary focus of financial reporting. The Board also reinforced its stance in para BC4.94(b) of the Basis that information about transactions would be relevant to financial statement users and much of financial reporting would continue to be based on transactions. Nevertheless, despite the Board’s caveat in the Basis, there is indeed a downplay on the matching principle in the Framework and we evaluate whether this downplay is warranted.
AN ASSET-LIABILITY APPROACH AND DEFERRED COSTS
Under current IFRS, some costs are accounted for by capitalising and amortising them over future periods as expenses, that is, deferred costs. An example is a deferred staff cost arising from an interest-free loan given to an entity’s employee who has a service bond. In this situation, the initial difference between the fair value of the loan and the cash disbursed to the employee is treated as a deferred staff cost and amortised over the period of the loan (IFRS 9 Financial Instruments).
Similarly, the recent revenue standard – IFRS 15 Revenue from Contracts with Customers – takes a performance approach to revenue recognition (instead of the conventional approach of assessing the probability of cash inflows). IFRS 15 also calls for deferring costs to obtain contracts and amortising those costs as performance is rendered over the contract period. An example of such costs would be a commission fee for obtaining a construction contract. The capitalised commission fee would be amortised to contract expense over the duration of the construction contract.
A pertinent question concerning deferred costs is whether their capitalisation meets the definition of an asset. An asset is defined in the Framework as “a present economic resource controlled by the entity as a result of past events” (para 4.3) and an economic resource is “a right that has the potential to produce economic benefits” (para 4.4). Unlike intangible or physical assets, it is questionable whether the abovementioned deferred staff cost produces economic benefits through its recovery – either from use or sale1. Likewise, capitalised incremental costs to obtain a contract are not economic resources that can be used to satisfy contractual performance obligations in the future.
The capitalisation of certain costs as deferred costs required by some IFRS seems to be inconsistent with the recognition of assets stipulated in the Framework. On the other hand, the deferment of costs is supported by the matching principle when costs are incurred but their associated income is not recognised now but only in future periods. However, deferment of costs based on matching income and expenses appears to be impermissible under the current Framework as para BC4.94(e) of the Basis states that “an intention to match income and expenses does not justify the recognition in the statement of financial position of items that do not meet the definitions of an asset or a liability.”
Similarly, not all expenses arise from recognition of changes in assets or liabilities as maintained by the Framework. One exception is the recognition of staff costs associated with equity-settled employee share option plans where the corresponding effect is an increase in equity in the form of a reserve under IFRS 2 Share-based Payment. Again, the recognised staff costs under an equity-settled employee share option plan are more aligned with the need to match expenses to income rather than the recognition of changes in assets or liabilities as maintained by the Framework.
The current asset-liability approach in the Framework views recognition of expenses and income as resulting from the recognition of assets and liabilities, and their changes. While the Framework does not explicitly prohibit matching of income and expenses, it is stated in the Basis that matching should not be used as a justification to recognise costs as assets if they do not meet the definition of an asset. However, this stance seems to be at odds with deferred costs and expenses recognised under some current IFRS as illustrated earlier, which are more consistent with the matching principle. Until all IFRS are realigned with the (asset-liability orientated) recognition principles advocated in the Framework, we believe there is a need for the Framework to be more explicit in acknowledging the relevance and usefulness of matching in explaining the recognition of certain (albeit exceptional) expenses and assets.
Choo Teck Min is Academic Director of the MSc (Accountancy) programme, Nanyang Business School, Nanyang Technological University (NTU), and Low Kin Yew is Co-Director, Interdisciplinary Collaborative Core (ICC) Office, and Associate Professor (Practice), Nanyang Business School, NTU.
1 Some argue that the service bond accompanying an interest-free employee loan allows an entity to control the employee, an economic resource, during the loan tenure.