R company putchased many tools during 2007 at a total cost of $8,100. Some tools were expected to last a few weeks, some for several months, and some for several years. R companys income for 2007 will be about 4.5 million. How should R company account for the tools in order to be theoretically correct? As a practical matter, how should R company account for these tools? Why?
***I am supposed to indicate the accounting principle or concept that applies***
In order to account for the tools, R company should consider the matching principle. The matching principle states that expenses should be recognized in the same period as the revenues they help to generate.
The first step in applying the matching principle is to estimate the useful life of each tool. Since some tools are expected to last a few weeks, some for several months, and some for several years, R company should allocate the cost of the tools over their respective useful lives.
For the tools expected to last a few weeks, R company should expense the entire cost in the same period when they were purchased. This is because their useful life is short and they are considered to be consumed or used up within a relatively short period.
For the tools expected to last for several months, R company should allocate the cost over the months in which they are expected to be used. This is usually done by dividing the total cost by the estimated number of months of useful life, and recognizing an equal portion of the cost as an expense each month.
For the tools expected to last for several years, R company should allocate the cost over the years in which they are expected to be used. Again, this is done by dividing the total cost by the estimated number of years of useful life, and recognizing an equal portion of the cost as an expense each year.
On a practical basis, however, many companies choose to simplify the process by treating all tools as expenses when they are purchased. This is known as the expense recognition principle. By expensing the entire cost upfront, R company can simplify their bookkeeping process and avoid the need for tracking the useful life of each individual tool.
The reason behind this practical approach is that the cost of the tools is relatively small compared to R company's expected income of 4.5 million for 2007. Treating the tools as immediate expenses would not materially impact the overall financial statements or distort the financial performance of the company.
In summary, while the theoretically correct approach would be to allocate the cost of tools over their useful lives, for practical reasons, R company can choose to expense the entire cost upfront. This decision is based on the materiality of the cost compared to the company's overall income and the simplification it provides to the accounting process.