What is a cost for financial reporting?


In financial accounting, a cost is a consumption of resources resulting in a destruction of wealth and all changes in wealth are ultimately recorded in the income statement. A relatively simple rule you can follow to determine what is a cost from a financial accounting perspective is to ask yourselves whether it changes the value of your assets in the current period (time matters!) and will eventually impact equity (the wealth invested by the owners) through the income statement. For instance, consider the following transactions:

Solution. “No” means this is not a cost; “Yes” indicates that this is a cost:

  1. No: when you buy the equipment, it has the value of the cash you invested in it and in theory, you could sell it for the same amount. Therefore there is no change in wealth.
  2. Yes: depreciation accounting for the decreasing value of your asset and it is a wealth destruction which affects the income statement;
  3. No: just like the equipment, when you buy raw materials, it has the value of the cash you spent and in theory, you could sell it for the same amount. Therefore there is no change in wealth.
  4. Yes: when you consume raw materials, you destroy them to transform them into something else. You sacrificed the raw materials to hopefully obtain something of greater value; but since there is a sacrifice, there is a cost.
  5. Yes: the service will result in a decrease in assets and is consumed during the period, so it is a cost of the period.
  6. No: the service is not consumed yet, so you bought a right so an asset (prepaid expenses are like inventory) of equal value. When the period for which you paid the rent will start, you will start consuming the services and only then there will be a cost.
  7. No: here, your asset base decreases (cash goes out), the counterpart is a reduction of your debt; it does not affect the income statement so it is not a cost. A change in cash is not a change in wealth, and costs are only changes in wealth!
  8. No: same reason as 7.
  9. Yes: the accrued interest is a resource sacrificed to obtain financing in the current period (you consume a service for which you will eventually pay, so your asset base will eventually decrease) and the counterpart is indeed an expense reducing your net income.
  10. No: same reason as 7. and 8.: reimbursing a debt does not change your overall wealth, so it is not a cost.
  11. Yes: for reasons similar to 9.: the accrued income taxes is a resource sacrificed for the State to allow you to operate in the current period (you consume a service for which you will eventually pay, so your asset base will eventually decrease) and the counterpart is indeed an expense reducing your net income.
  12. No: this one is tricky as it affects equity and will eventually result in a decrease in cash. But it does not affect equity through the income statement. The payment of a dividend is conceptually more like reimbursing a debt (points 7. and 8.): you give back to your owners the money which belongs to them in the first place.
  13. No: because dividend is not a cost (point 12.) and change in cash is not a change in wealth.

So how well did you do? Tough isn’t it?


Note that the timing of the resource consumption matters. The timing of the payment however does not and can therefore be misleading. Keep in mind that the period in which the cost or expense is recognized is not necessarily the period where cash flows occur. In management accounting, we are interested in when resources are consumed, which is also when they should be recognized, and not when the cash flow actually happens. Look at the following example:

Solution. Accrued wages are wages due to the employees because of past services which were not paid yet. In other words, their work has been consumed in prior periods but not paid yet. Accrued wages at the beginning of the period should therefore be subtracted since they are not costs of the current period. On the contrary, once you subtracted accrued wages at the beginning of the period, accrued wages at the end of the period relate to labor consumed in the period but not paid yet; they should therefore be added to the costs of the period. The total labor costs of the period is therefore:

\[ \begin{aligned} \text{Cost of the period} & = && + \text{payment in current period} \\ & && - \text{payment for consumptions of prior periods} \\ & && + \text{unpaid consumption of current period} \\ \\ \leftrightarrow \\ \text{Cost of the period} & = && 50,000 - 5,000 + 3,000 \\ \text{Cost of the period} & = && 48,000 \end{aligned} \]



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