Expired Costs

Expired costs are costs whose future benefit has been used up or has disappeared. While a cost still promises benefit in a later period, accountants treat it as an asset, sometimes called an unexpired cost. Once that benefit has been consumed, the cost has "expired" and is moved to the income statement as an expense, or as a loss if it expired without producing any revenue at all.

The term is old-fashioned but useful, because it explains why the same payment can appear on the balance sheet one month and in the expense lines the next. It rests on accrual accounting and on the idea, often called the matching principle, that expenses should be recognized in the same period as the revenue they help earn.

Every asset that is not cash or a receivable can be thought of as a bundle of costs waiting to expire. They expire in a few typical ways:

• With the passage of time, as when twelve months of prepaid insurance or rent are used up month by month.
• Through use, as when equipment wears out and its cost is spread over its life through depreciation.
• Through a sale, as when inventory is delivered to a customer and its cost becomes cost of goods sold.
• Through sudden loss, as when goods are destroyed by fire or an asset suffers an impairment and its recorded cost can no longer be recovered.

Some costs expire as soon as they are incurred. Office electricity, sales commissions and advertising are generally treated as expenses right away, because there is no reliable way to link them to a future period.

On 1 January a company pays $12,000 for a one-year insurance policy. On that date the full $12,000 is unexpired and is recorded as prepaid expenses, a current asset. At the end of each month, one twelfth of the coverage has been used, so $1,000 of the cost expires. The monthly adjusting entry debits insurance expense for $1,000 and credits prepaid insurance for $1,000. By 31 March, $3,000 has expired and appears in expenses, while $9,000 remains on the balance sheet as an asset.

A second example is inventory. A retailer buys 200 lamps at $25 each, for $5,000. If it sells 150 lamps during the quarter, $3,750 of cost expires and is reported as cost of goods sold. The remaining $1,250 stays in inventory as an unexpired cost until those lamps are sold, written down or thrown away.

Most expired costs become ordinary expenses, which are costs that were used up in earning revenue. A smaller group become losses, which are costs that expired without helping to earn revenue, such as uninsured damage or a write-off of obsolete stock. The distinction affects presentation: losses are often shown separately, below operating income, so readers can see that they are not part of normal trading. Costs that will benefit several future years, such as a building, expire slowly through depreciation, while intangible assets with finite lives expire through amortization.

Deciding when a cost expires is one of the main judgments behind reported profit. If a company keeps costs on the balance sheet after their benefit is gone, it overstates both assets and income. If it expenses costs too early, it understates them. Auditors therefore test whether capitalized costs really will benefit future periods and whether the rate at which assets are expensed is reasonable. The same thinking appears in the adjusted trial balance prepared at each period end, where adjusting entries move expired portions of prepaid items, supplies and fixed assets into expense before the statements are issued.