A.

Product costs and Period costs are cost classifications used to prepare financial accounts for a particular
company. These are 2 types of costs that are incurred to a company during the production and sales of a
particular product or service.
The major differences between the two are based on the timing of when they are expensed.

PRODUCT COSTS: Product costs are incurred by a company to produce a product. These expenses are directly
related to the production of any specific product. They are incurred by a company to convert raw materials into
finished goods. Product costs are first recorded as inventory on the balance sheet and are expensed as cost of
goods sold (COGS) as soon as the finished goods have been sold. For manufacturing companies, products are
divided into 3 parts:
Direct materials: Raw materials and parts directly used to manufacture the finished product.
Direct labor: Labor and man power directly used to manufacture the finished product.
Manufacturing overheads: These include all the indirect costs that are necessarily incurred for the production
but cannot be directly used to produce the product.

PERIOD COSTS: Period costs are costs that are not related to the production of a particular product but are
incurred during the selling and administration of the product. Period costs are directly recorded in the income
statement right when they are incurred. All selling and administrative expenses are included in period costs.

DIFFERENCE BETWEEN PRODUCT COSTS AND PERIOD COSTS:

1. Products costs are directly related to the production of a product whereas period costs are related to the
selling of the product.
2. Product costs are first included in the inventory valuation while period costs are directly recorded as expenses
in the income statement.
3. Product costs are included in the cost of production but period costs are not.
4. Product costs are only incurred if the company produces any product whereas period costs are incurred even
when the company does produce any product.
5. Wages of workers in a factory is product cost but salary of a sales manager is period cost for the company.
B.

Manufacturing costs are the ones that are directly attributable to the production of an item. This could include
material, labour and production overheads. Advertising can be described as a means of communicating the
existence, qualities and features of a product with a view to securing or expanding market share. Expenses
incurred are not directly attributable to the production of units hence, generally treated as period costs.

Both period costs and manufacturing costs are elements of the income statement and are applied at different
levels. Manufacturing costs form cost of goods sold (COGS hereafter) and are deducted from revenue to arrive
at the gross margin while period costs are treated as operating expenses and are deducted from the gross margin
to arrive at net operating income. Treating advertising as a manufacturing cost overstates COGS leading to an
understated gross margin. At the same time, it will understate total operating expenses, but net operating income
would remain the same as advertising expense has already been deducted from sales at an earlier stage.

Consider the following example:

Sales: 100
COGS: 50
Advertising: 20
Admin: 20

Scenario 1 Scenario 2
Sales: 100.00 Sales: 100.00
COGS: - 50.00 COGS: - 60.00
Gross Margin 50.00 Gross Margin 40.00
Advertising: - 20.00 Advertising: - 10.00
Admin: - 20.00 Admin: - 20.00
Operating Income 10.00 Operating Income 10.00

In scenario 1, advertising is accurately treated as a period cost and is deducted from the gross margin to arrive at
operating income. In scenario 2, $10 of advertising expense has been treated as manufacturing cost and is
deducted from sales. In both cases, the operating income remains the same but the gross margin changes.

In summary, the only financial statement that gets affected by treating advertising as a manufacturing expense is
the income statement and the impact is limited to the line items COGS and gross profit. However, as a result,
there is a risk of inaccurate financial analysis; break even analysis and certain profitability ratios for instance.

C.

Explain the impact of reclassifying the advertising costs from inventory to prepaid advertising. Which financial
statement(s) would be affected and how?

Prepaid expenses can be considered assets provided that they are used and controlled by the entity incurring the
expense and the entity expects to receive economic benefits from them over their lifetime. Prepaid expenses are
intangible assets and form part of the current assets of the entity. In the case of Nickle Products reclassifying
advertising expenses as a prepaid asset can have an impact on multiple financial statements. A point to note is
such reclassification requires the company to receive economic benefits from the incurred expense at least over
two or more accounting periods and the asset needs to be duly amortised over its useful life.

Income Statement

The current practice is to treat advertising as manufacturing costs which form part of COGS. This is
questionable indeed as advertising is not directly linked to the manufacturing of a product. The proposed
reclassification will remove the element of advertising from COGS which would lead to an increase in gross
margin. This increase will follow all the way to the bottom line and the income statement will reflect a higher
net profit.

If Ashley plans to amortise the asset, a monthly figure will be written off to the income statement as an expense.
Depending on where she applies it, either COGS (if treated as manufacturing expense) or operating expenses (if
treated as period costs), will be increased by the amortization amount and will impact profit lines as explained
in the previous answer.

Statement of Financial Position/Balance Sheet

As explained earlier, prepaid expenses are treated as intangible current assets provided that they meet the
criterion to be classified as assets. The proposed reclassification will increase the current asset value by the
amount of expense incurred. This will result in an increase in total assets value on the balance sheet.

Statement of Cash Flow

As explained earlier, the proposed reclassification will result in an increase in net operating income. This will
increase the cash flow from operating activities, thus increasing the net cash flow in the period concerned.
Statement of Changes in Equity
The increase in net profit arising from the reclassification will increase the line item “profit for the year” figure
in the statement of changes in equity, thus improving the cash position of Nickel Products.

D.

The current practice of Nickel Products is to treat advertising expenses as part of manufacturing cost. As
explained earlier, advertising is not directly related to the manufacturing of a product, thus deems the accuracy
of this treatment questionable. This element of advertising inflates the COGS leading to an understated gross
margin which would follow all the way to the bottom line.
As the company attempts to pivot the way advertising is treated, Ashley needs to carefully consider what the
best alternative is. As explained earlier, prepaid advertising is a current asset and before the reclassification, she
needs to make sure that the advertising expense meets the criterion discussed earlier to recognize it as an asset.

If put in place, the proposed reclassification will impact the following financial statements as explained below.

Income Statement

Reclassifying advertising as prepaid expenses will eliminate the overstatement of COGS arising from the
element of advertising inaccurately treated. This will lead to a more accurate reflection of company financials
when the gross margin as well as the net margin increase.

The monthly amortization amount will still be deducted from the income statement, ideally from the gross
margin to arrive at the net operating income. This will bring down the bottom line figures reported but is a more
accurate representation of the financial performance of Nickel Products.

Balance Sheet

Prepaid expenses are considered current assets on the balance sheet. When advertising is reclassified as prepaid
expenses, the value of the current assets will go up. This will provide a more accurate reflection of the financial
position of Nickel Products with a higher total assets value and a higher net asset value.

Statement of Cash Flow

The proposed reclassification will increase cash from operating activities as it increases the net operating
income. This will lead to an overall positive impact on the cash flow of the company.
Statement of Changes in Equity

As explained earlier, the proposed reclassification leads to a reduction in COGS which would be reflected in an
increase in the net profit. This will lead to an increase in the line item “profit for the period” in the statement of
changes in equity.

E.

Accountants are primarily responsible for the preparation of financial statements. These financial statements are
used by a variety of stakeholders including investors, regulatory bodies and government agencies such as CRA.
This renders the information provided on financial statements highly critical and acted as a reason for regulatory
bodies such as International Accounting Standards Board to develop rules and guidelines in the preparation of
accounting entries. Despite the existence of these rules and guidelines, well informed performers can find ways
to alter the information presented. This is where the professional values of the performers come into place.
Accountants are supposed, in addition to professional competence, to exercise integrity and ethical behaviour.

The implications of classifying period costs as product costs would include;

i. Misinterpreted Cost: The true cost of creating items may be misrepresented if period costs are
reclassified as product costs. Direct materials, direct labour, and manufacturing overhead directly
related to the production process are often associated with product costs. The corporation
fraudulently inflates the cost of goods sold and inventory value by incorporating period charges like
advertising expenses as part of product costs. This distortion may deceive stakeholders who depend
on reliable financial reports to evaluate the performance of the business and make wise decisions.

ii. Misrepresented performance and profitability: Increasing product costs would cause an artificial
reduction in the gross profit margin, which is determined by subtracting the cost of products sold
from revenue. This could affect how the company's profitability is evaluated and how its financial
performance is compared to competitors' or industry benchmarks. Reclassifying expenditures could
also make it more difficult for the business to pinpoint inefficient regions and deploy resources
efficiently.

The above implications mean there is going to be a significant impact on all stakeholders and the decisions they
will be making based on the information provided. This deems the reclassification of period costs to product
costs unethical. On top of that, inaccurate financial statements pose a risk of audit findings and the accountants
involved in the preparation of financial statements could be held responsible.

2. What would you do if you were Ashley? (2 marks)

Ashley is under pressure and is facing a conflict of interest as the president suggests a different approach to
what she has in mind. As the controller, she needs to exercise due competence and integrity in all her
professional endeavours. The problem she is facing is whether to treat advertising as a period expense or to
classify it as a prepaid expense as suggested by the president. Before choosing an option, she needs to consider
the implications of each option as well as the level of compliance with IFRSs.

Advertising campaigns are generally run for at least a couple of months. If the total cost incurred is expensed
over one accounting period (month), Ashley will be going against the matching concept which advocates the
allocation of expenses over the whole period the economic benefits are expected to flow from the advertising
campaigns. This will also have a huge negative impact on the financial performance of the company reflected
on the income statement. This renders the approach Ashley has in mind inappropriate.

The president suggests advertising be classified as a prepaid expense. This means, it will be reflected on the
balance sheet as a current asset. Before recognising an expense as an asset, Ashley needs to make sure it
reasonably meets all the criteria for the recognition of an asset. As explained in the previous paragraph, one can
expect the advertising campaign to run for at least several months. Nickel Products will own the campaign and
it can reasonably be expected to generate economic benefits over the period it will be active.

In this light, the most accurate out of the two options would be to treat advertising as a prepaid asset as
suggested by the president. The whole amount paid needs to be recorded as prepaid advertising. Not only will
this be the most appropriate accounting treatment but also will keep the president of the company satisfied
whilst improving the accuracy of the financial statements of Nickel products.

Once recognised as an asset, the total amount paid needs to be divided by the number of months the campaign
would run and the monthly amount needs to be written off to the income statement. In doing this, Ashley needs
to make sure the amortization amount is categorised under operating expenses instead of manufacturing
expenses as it was done earlier. The value of the prepaid asset created will gradually come down every
accounting period and at the end of the life of the advertising campaign, it will come down to zero.
In summary, I recommend that Ashley treats advertising as a prepaid expense and amortise over the life of the
campaign.