Last week, my post discussed the principle of accounting for operating inflows referred to as the revenue recognition principle. Continuing with the overarching theme of accrual accounting, this week I’ll write a few things about the application of measuring outflows (i.e. expenses) from operations.

To understand expenses, it’s important to discuss assets. Assets are found on the balance sheet and are resources available for an entity to work with toward generating revenues. In the process of generating revenues (sales is the key revenue), assets are used up, with the exception of land which is deemed to have an infinite life. An expense is recognized in a given accounting period for the portion of the asset deemed “used up” in that period in the process of the asset being used to generate revenue.

It is important to note that an expense, under the concept of accrual accounting, is not simply a synonym for “cost.” Land, for example is a “cost” in that it costs money to acquire it. However, the cost of land will remain recognized as an asset on the balance sheet and never become deemed an expense of operating because again, the cost of land is seen as one that will never expire (be used up). Basically an asset is an unexpired cost and an expense is an expired cost.

To determine how much of an asset is used up in a given accounting period of operations (quarterly period or annual fiscal period), the accrual principle of expense recognition attempts to “match” the life of the asset to the process of incrementally writing off the asset to an “expense” account.

Last week, I commented on how the revenue recognition principle involved corporate management’s judgment in determining the practical application of when monies from operating become both “earned” and “realizable.” Likewise, the principle of charging off some portion of an asset involves corporate management’s judgment as to when and how much an asset has been diminished. For example, when and how much depreciation to record is as much an art as a science. At the time a company acquires a long-lived fixed asset like a piece of machinery, it does not absolutely know how long the asset will prove useful, what its residual value will be upon disposal, which depreciation method is going to best “match” the reality of how revenues will be derived from the asset, etc. Yet, these elements will have to judged at the time of acquisition in order to record depreciation expense period by period

Intentionally over-simplifying a bit, net income, frequently referred to as “earnings” in the world of common stock investing, is the excess of revenues over expenses. I say oversimplifying in that earnings can also involve recognized gains and losses and be effected by non-recurring events. But the essence of accrual practice in measuring earnings for a given accounting period is to recognize the revenues and the expenses relative to that period, not based on the timing of cash inflows and outflows but based on the revenue recognition and expense recognition (matching) principles, respectively.

A short while back, I mentioned Hewitt Heiserman’s book, “It’s Earnings That Count,”which presents a strategy for investigating the quality of reported earnings. Because earnings are the usual catalyst for moving shareholders to drive stock prices up or down, keep in mind always that the practice of accrual accounting in measuring earnings is riddled with management judgment calls. We want to avoid companies where management seems inclined to stretch judgment calls to report higher earnings that lack quality.

We need accrual accounting because, as investors, we need to be able to predict future cash flows; so the accrual of financial events that will impact cash now and later is essential to our forward-looking analysis. Please note that accrual accounting is not itself the threat earnings quality. It is the potential abuse from self-interested judgments made by management that explains the need for the audit function and also explains why I’m writing about the basic accrual accounting principles of revenue recognition and expense recognition. To invest in individual stocks, one must understand enough about the creation of numbers to evaluate and use them properly.