Lecture 3 (Cost flows and cost terminology) In this module, we will discuss how firms accumulate costs for financial reporting purposes. We will examine the process of cost accumulation in three types of organizations: service, merchandising, and manufacturing. We will scrutinize the similarities and differences in the flow of costs in these organizations, focusing particularly on how they accumulate costs for valuing inventory and reporting income. Because cost allocations play an integral role in this process, we end our discussion of this module with a brief overview of the mechanics of cost allocations. What we are going to discuss in this module is important because we need data to estimate costs and benefits. Invariably, we get this data from the accounting system and most systems are set up to comply with GAAP. Accordingly, it behooves us to understand how such systems work.

All costs incurred are eventually recognized as expense in the income statement. However, some costs are recognized as expenses immediately and some costs are recognized as expense after a lag. The timing with which the costs of acquiring assets or services are recognized as expense is an important issue in accounting. An expense is defined as the cost incurred when an asset is used up or sold for the purpose of generating revenue. The terms product cost and period cost are used to describe the timing with which various expenses are recognized. A product cost is a cost assigned to goods that were either purchased for resale or produced for sale. In the period of the sale, the product costs are recognized as an expense called cost of goods sold. GAAP requires that costs are grouped according to business function. Therefore, costs associated with production of goods and services or procurement of merchandise is called product costs and they are not necessarily expensed in