How Companies Classify Expenses
Your audit client’s expenses are all the costs it incurs while keeping its business open. Most likely, these costs are a combination of expenses you find very familiar, such as telephone and utilities, and industry-driven costs that you have to become familiar with. For example, a scientific research company may have expenses for tools and supplies with exotic names such as photoelectric colorimeter. As an auditor, you’re responsible for having a firm grasp of your client’s expenses.
How a company classifies an expense depends on the category the expense falls into. Using generally accepted accounting principles (GAAP), business costs fall into three general categories:
Product costs: Any costs that relate to manufacturing an item for sale to customers are product costs. A common example is cost of goods sold, which reflects all costs the company incurs when making the items sold in the current period. For a retail shop, cost of goods sold is what it pays to buy the goods that it sells to its customers.
Period costs: These costs, while necessary to keep the business doors open, don’t tie back to any specific item the company sells. Examples of period costs are shop rent, telephone expense, and office/shop salaries.
Systemic costs: This category includes expenses a company logically allocates to financial periods based on when it receives the benefit of the expense. A good example is depreciation. When a company purchases a long-term asset like a computer or machine, the cost of the asset is spread over its useful life, which may be years after the purchase. Many companies depreciates shop furniture, fixtures, and equipment.