The generally accepted accounting principles require us to report expenses in the income statement for the year when they were incurred in order to generate the revenue for the current period only.
The matching principle of accounting says that the costs should match the revenue for the year.
Period costs are costs that were incurred in the current year only but exclude any expenditure that is capitalized in any of the assets i.e. inventory or fixed assets. These are costs which are more related to the passage of time than the number of units.
This implies that the cost of goods sold which includes direct material, direct labor, factory depreciation etc is excluded from period costs even if it matches the revenue generated.
Period costs also excluded any expenditure incurred for purchasing a fixed asset and bringing it to its current condition i.e. any capital expenditure.
The prepaid expenses are not a part of period costs either because they do not relate to the current period, instead paid for future accounting periods.
Any prepaid rent, bills or insurance is not a period cost rather a current asset that shall be reported on the balance sheet.
Financial statements are a set of four documents that present the yearly financial achievements and expenditures the company has incurred.
It helps us understand how profitable and liquid the business has been and gives us an insight of the assets, liabilities and equity held by the company. The four financial statements are commonly known as follows:
- Statement of comprehensive income
- Statement of financial position
- Statement of cash flow
- Statement of changes in equity
All the transactions are entered in the ledgers by passing entries. These ledgers are converted into trial balance which is then transformed into financial statements.
Period cost is one of such items that must be reported on the financial statements.
1) Period cost in income statement:
Period cost is a line item of the statement of comprehensive income. All the operating expenses which include rent, depreciation, utility bills, bad debts, insurance, salaries and wages, interest expense, and others are reported on the income statement or statement of comprehensive income. The formula for calculating the net profit for the year is:
Revenue – Cost of Goods Sold – Operating Expenses
Operating expenses are revenue expenditures incurred to provide consumables to the business in order to keep it running.
Period costs are a part of operating expenses and are deducted from the gross profit (Revenue – Cost of goods sold) in order to achieve the net profit.
2) Period cost on balance sheet:
The period costs exclude any prepaid expenses that do not match the revenue for the current year. However, any accrued expenses for the year are included in the period cost, for example, a company failed to pay the rent for December and will pay for it in the next accounting period.
Even though the rent has not been paid for but it relates to the current period or passage of time and shall be reported under the head period costs. Such accruals shall be reported as current liabilities on the balance sheet along with payables and overdrafts.
3) Period cost on statement of cash flow:
As explained above, period costs are the costs that match the current period’s revenue only. So even if an expense has been accrued and will be paid for in the future, it shall be reported on the income statement as a period expense.
Such accrued expenses are non-cash items. When the net cash flow from operating activities is calculated, an increase in accruals is added to the operating profit and a decrease in accruals is deducted from the operating profit.
Period cost on statement of changes in equity: There is no impact of closing inventory on statements of changes in equity.