Maybe you can run your sewing machines for 10,000 hours before they need repairs. You might find that your commercial printing press has a maximum number of print jobs it can perform without breaking down. If you need production capacity above the relevant range, you need to invest in another asset. That investment is a cost.
Relevant range isn’t just about breakdowns and maintenance. Even if your machinery works as expected, there’s only so much capacity you can handle. Say you have machine capacity to produce 1,000,000 gloves a year. If you want to increase production to 1,200,000 gloves, you need more machines. That means an investment in more fixed assets.
Previewing inventoriable costs
Inventoriable costs are costs that can be traced to your inventory. That includes the purchase price of the inventory item. However, there are other costs that should be added to the asset’s cost. You refer to these costs as inventoriable.
Let’s say you own a furniture store that sells lamps. You carry an expensive model of lamp in your store. Parts of the lamp can break easily. As a result, it’s expensive to ship the lamps. When the lamps arrive, they’re stored carefully to prevent breakage.
Your inventory value for the lamp obviously includes the purchase price. It should also include all costs to prepare the asset for sale, such as the shipping cost and any extra costs you incur to store and display the lamp.
Now consider the impact of including more costs in inventory. Inventory costs aren’t posted as expenses (expensed) until the asset is sold. All the lamp costs remain in inventory until a lamp is sold. At that point, the lamp cost is posted to cost of sales (also called cost of goods sold).
Other costs are expensed as soon as they are incurred. A good example is marketing costs. Marketing costs are immediately expensed, because it’s difficult to know if and when the costs generated a sale.
If you run a million-dollar ad during the Super Bowl for running shoes, it’s not possible to know how many shoes were sold as a result of running the ad. So you expense it sooner than later. This is the principle of conservatism, which is explained in the next section.
Following the Rules of the Cost Accounting Road
Accountants are big on rules and guidelines. When you have to make a decision as an accountant, you first check for rules and guidelines. Some rules are regulations or laws. This section talks about some critical guidelines you should use in accounting.
Understanding generally accepted accounting principles (GAAP)
Generally accepted accounting principles (GAAP) refer to the rules that accountants must follow when preparing financial statements. The Financial Accounting Standards Board (FASB) is the industry organization that issues GAAP requirements.
The accounting industry’s goal is to generate financial statements that are easier to understand. If every business follows GAAP requirements, the financial statements are comparable between companies. The focus of GAAP is on financial statement users.
Considering the needs of stakeholders
You have a number of stakeholders who need timely and accurate financial statements, including these two groups:
Creditors: If you take out a business loan, your banker will need to see your firm’s financial statements. Your financial performance determines whether you can make principal and interest payments on your loan.
Investors: An investor can profit from selling an investment for a profit, or by receiving a share of a company’s earnings as a dividend. Your investors want to know if your firm is profitable, and if sales are growing over time.
To apply GAAP standards, you need to know the basics. Remember that the goal of using GAAP is to create financial statements that are clear and consistent, so that stakeholders understand company results.
Mulling over consistency
GAAP allows financial statements readers to make “apples to apples” comparisons. A good example is accounting for fixed assets. Generally speaking, fixed assets must be valued at historical cost, meaning the amount paid for the asset. The cost of the asset includes acquisition cost (the check you write for the asset), plus shipping and other costs required to prepare the asset for use.
Say, for example, that two trucking companies each list ten trucks as fixed assets in the balance sheet, and that all the trucks are the same size. If both firms comply with GAAP, the trucks are valued at historical cost less accumulated depreciation.
OK, now assume that company A’s trucks are listed in the balance sheet at $100,000, while B’s trucks have a value of $200,000. What does this data tell you? On average, A’s trucks are worth less than B’s trucks, and that also means that A’s trucks are older and must be replaced sooner.
Company A will have to invest in new trucks before company B. If you were considering investing in either company, that difference would impact your investment decision. A is going to have to spend money on trucks sooner than B, and that leaves less money for other needs.
Deciding on accrual basis or cash basis
The cash basis of accounting recognizes revenue when cash is received and posts expenses when they are paid in cash. This method means that you post your accounting activity based on when cash moves in or out of your business. It’s accounting by “using your checkbook.”
Recognizing revenue or expenses refers to the timing of when you post the amounts to your accounting records.
Installing the cash basis
There’s a problem with the cash basis of accounting — it doesn’t follow the matching principle. This principle requires accountants post revenue when it’s earned and expenses when they are incurred.
The matching principle is a two-step process. Your first step is to determine when revenue is earned. You earn revenue when you deliver your product (as explained earlier), or complete a service you perform for a customer. You may receive payment in advance of the delivery, or a few weeks after the delivery. When you earn, the revenue may be different from when you receive the cash payment.
For a retailer, revenue is earned when the customer walks out of the store with, say, a new baseball glove. If you’re a tax preparer, you earn revenue when you deliver a completed tax return to your client.
After you determine when revenue is earned, you match the revenue to the expenses that are related to the product or
