Inventories or Stocks – Part 3, Cost Formula

In Example 1 of my previous post, Inventories or Stocks – Part 2, Methods of Recording in General Ledger, the cost of purchasing inventories had been fixed in order to show the effect of two different methods of recording in General Ledger clearly. In reality, cost of inventory purchases fluctuates from time to time. Let’s explore the common ways of calculating the cost of inventories when purchase price fluctuates from time to time – This is called the Cost Formula of inventories. There are three common Cost Formulas for inventories: –

  1. FIFO (First-in-first-out)
  2. Weighted Average
  3. LIFO (Last-in-last-out)

Please take note of the difference between Cost Formulas (FIFO, Weighted Average or LIFO) and the methods of recording inventories in General Ledger (Periodic Method or Perpetual Method). A business entity could choose a combination of the following in recording its inventories: –

Methods of recording in General Ledger

Cost Formula

Combination 1

Periodic

FIFO

Combination 2

Periodic

Weighted Average

Combination 3

Periodic

LIFO

Combination 4

Perpetual

FIFO

Combination 5

Perpetual

Weighted Average

Combination 6

Perpetual

LIFO

As you can see from the above table, the choice of cost formula to be used is independent of how an entity chooses the method of recording inventories in the General Ledger.

Referring to the transactions ABC Co. Ltd. in Example 1 of my previous post, assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

  1. Inventories or stocks on hand as at 31 December 2005 comprised the following:-

    Quantity

    Unit Cost

    Total

    $

    $

    Stock Type A

    100

    5

    500

    Stock Type B

    200

    7

    1,400

    Stock Type C

    250

    20

    5,000

    6,900

  1. 15 January 2006

    Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

  2. 20 January 2006

    Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

  3. 21 March 2006

    Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

  4. 31 July 2006

    Purchase of 50 units of Type A stock at $6 each, on credit. Total purchases were $300.

  5. 30 September 2006

    Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

  6. 30 November 2006

    Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1

Stock Type A

Stock Type B

Stock Type C

Quantity

Quantity

Quantity

Balance as at

1 January 2006

100

200

250

Stock in:
20 January 2006

100

31 March 2006

50

Stock out:
15 January 2006

(50)

21 March 2006

(300)

30 September 2006

(75)

30 November 2006

(150)

Balance as at

31 December 2006

25

100

You would notice that all the above transactions are exactly the same as shown in Example 1 of my previous post except for Transaction e. The purchase cost of Stock A was $6 per unit instead of $5. The difference in this purchase cost requires certain cost formula to determine value of the inventories in hand as at 31 December 2006 and also to determine the cost of goods sold or cost of sales of 75 units of Stock A sold on 30 September 2007. Please take note that the cost of goods sold for the 50 units of Stock A sold on 15 January 2006 makes no difference in terms of the difference cost formula used because the cost per unit of Stock A prior to the sale of this 50 units of Stock A was $5 per unit (assuming the 100 units of Stock A in hand prior to this sale is from the same batch of purchase). The cost of sale and the unit cost of Stock A during the financial year ended 31 December are shown calculated under the three different cost formulas are below: –

FIFO (first-in-first-out)

Under the FIFO cost formula, the earliest batch of inventories would be given the priority over the subsequent batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 2

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 1

Stock out:
30 September 2006

(50)

(25)

(5)

(6)

*(250)

*(150)

Note 2

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

6

150

Note 3

Note 1: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $5 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 2: Under FIFO cost formula, the earliest batch of stock in hand i.e. the 50 units of Stock A @ $5 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand was therefore 25 units of Stock A @ $6.

Note 3: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006.

*: The total of $650 ($250 + $250 + $150) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006.

Weighted Average

Under the Weighted Average cost formula, the weighted average cost of all existing inventories on hand plus the new purchases is calculated and allocated to all inventories on hand (both old and new batch of purchases) with the same weighted average cost calculated. Table 3 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 3

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

100

5.5

550

Note 4

Stock out:
30 September 2006

(75)

(5.5)

*(412.5)

Note 5

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5.5

137.5

Note 6

Note 4: The weighted average cost of $5.5 was calculated by taking the total of the old batch of Stock A (50 x $5 = $250) plus the total of the new batch of Stock A purchased (50 x $6 = $300), divided by the total quantity of new and old stocks – {$250 + $300}/{50units + 50Units} = $5.5.

Note 5: Once the weighted average cost of $5.5 has been determined, the calculation of the cost of goods sold for this 75 units of Stock A is straight forward – 75 units x $5.5

Note 6: The calculation of closing inventories in hand is also straight forward – 25 units x $5.5

*: The total of $662.5 ($250 + $412.5) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

LIFO (last-in-first-out)

Under the LIFO cost formula, the latest batch of inventories would be given the priority over the earlier batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 4

Stock Type A

Quantity

Cost

Value

Refer

$

$

Balance as at

1 January 2006

100

5

500

Stock out:
15 January 2006

(50)

(5)

*(250)

Balance as at

15 January 2006 after the sale of 50 units

50

5

250

Stock in:
31 March 2006

50

6

300

Balance as at

31 March 2006 after the purchase of 75 units

50

50

5

6

250

300

Note 7

Stock out:
30 September 2006

(50)

(25)

(6)

(5)

*(300)

*(125)

Note 8

Balance as at

31 September 2006 after the sale of 75 units and remained unchanged until year end

25

5

125

Note 9

Note 7: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $6 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 8: Under LIFO cost formula, the latest batch of stock in hand i.e. the 50 units of Stock A @ $6 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand due for stock out was therefore 25 units @ $5 from the earlier batch of Stock A.

Note 9: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006

*: The total of $675 ($250 + $300 + $120) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

The double entries for recording inventories under both the Periodic and Perpetual methods had been shown in my previous post. Of course the figures for Stock A are different from those shown in Example 1 of my previous post, depending on which cost formula is chosen. Figures for Stock B and Stock C remained the same.

Did you notice that the three cost formulas shown above give different cost of goods sold and also different inventory value at the end of the financial year?

Another point to note is that LIFO cost formula is prohibited in some countries.

Inventories or Stocks – Part 2, Methods of Recording in General Ledger

There are two common methods of recording inventories or stocks in the General Ledger of business entities:-

1. The Periodic Method

2. The Perpetual Method

The choice of the method used will directly determine the double entries for the recording of inventories or stocks of the entity concerned.

1. The Periodic Method

Under this method, the inventories or stocks account in the General Ledger would not be updated regularly with the movement of inventories or stocks throughout the whole financial period until the last closing day of the financial period in which the new inventories balance would be determined and adjusted accordingly. The balance of the inventories or stocks account remained at the amount brought forward from the previous financial period i.e. the opening inventories or stocks for the current financial period (this is also the closing balance of inventories or stocks for the previous financial period). At the end of the current financial period, an inventories counting exercise would be conducted to determine the closing balance of inventories and once this is done, the inventories or stocks account in the General Ledger would then be adjusted to reflect the correct inventories or stocks balance on the closing date. On the closing date (i.e. the end of the current financial period), the cost of goods sold would also be determined and deducted against the sales or turnover figure recorded for the current financial period to get the gross profit amount. The steps involved are explained in the following illustration:-

Example 1

Assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

a. Inventories or stocks on hand as at 31 December 2005 comprised the following: –

Quantity

Unit Cost

Total

$

$

Stock Type A

100

5

500

Stock Type B

200

7

1,400

Stock Type C

250

20

5,000

6,900

b. 15 January 2006

Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

c. 20 January 2006

Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

d. 21 March 2006

Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

e. 31 July 2006

Purchase of 50 units of Type A stock at $5 each, on credit. Total purchases were $250.

f. 30 September 2006

Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

g. 30 November 2006

Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The double entries for the above transactions are: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Trade debtors

400

Sales

400

(Sales for January 2006)

c. 20 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Purchases

700

Trade creditors

700

(Purchases for January 2006)

d. 21 March 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 March 2006

Trade debtors

3,000

Sales

3,000

(Sales for March 2006)

e. 31 July 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 July 2006

Purchases

250

Trade creditors

250

(Purchases for July 2006)

f. 30 September 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 September 2006

Trade debtors

675

Sales

675

(Sales for September 2006)

g. 30 November 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 November 2006

Trade debtors

3,750

Sales

3,750

(Sales for November 2006)

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1

Stock Type A

Stock Type B

Stock Type C

Quantity

Quantity

Quantity

Balance as at 1 January 2006

100

200

250

Stock in:
20 January 2006

100

31 March 2006

50

Stock out:
15 January 2006

(50)

21 March 2006

(300)

30 September 2006

(75)

30 November 2006

(150)

Balance as at 31 December 2006

25

100

The amount of inventories as at year end i.e. 31 December 2006 was $2,125, comprising 25 units of Type A stock valued at $5 each (Total of Type A stock = $125) plus 100 units of Type C stock valued at $20 each (Total of Type C stock = $2,000).

Note: In this example, the cost of purchases of inventories during the year was intentionally fixed to remain the same as those as at 1 January 2006 for the purpose of simplifying the illustration of this topic. For Type A stock, the purchase of inventories made on 31 March 2006 was at $5 each, the same cost as at 1 January 2006. Similarly, for Type B stock, the purchase cost was $7. In reality, this may not necessary be the case as the price of goods do fluctuate from time to time. In Part 3, the methods commonly used by business entities to determine the unit costs of inventories will be discussed.

Once the closing inventories balance as at 31 December 2006 is determined, the following journal entries would be made to reflect the correct inventories balance: –

Balance Sheet

Income Statement

DR

CR

DR

CR

31 December 2006

Cost of goods sold

6,900

Inventories

6,900

(Being transfer of opening inventories to cost of goods sold account)

31 December 2006

Inventories

2,125

Cost of goods sold

2,125

(Being recognition of closing inventories)

The relevant accounts in the General Ledger of ABC Co. Ltd are as follows: –

ABC Co. Ltd

Page 10

General Ledger

Inventories

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
01-Jan Balance B/F

6,900.00

31-Dec Cost of goods sold GL45

6,900.00

31-Dec Cost of goods sold GL45

2,125.00

31-Dec Balance C/F

2,125.00

9,025.00

9,025.00

ABC Co. Ltd

General Ledger

Trade Debtors

Page 15

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Sales GL30

400.00

31-Dec Balance C/F

7,825.00

31-Mar Sales GL30

3,000.00

30-Sep Sales GL30

675.00

30-Nov Sales GL30

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Trade Creditors

Page 20

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Balance C/F

950.00

31-Jan Purchases GL40

700.00

31-Jul Purchases GL40

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Sales

Page 30

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Transfer to Income statement

7,825.00

31-Jan Trade debtors GL15

400.00

31-Mar Trade debtors GL15

3,000.00

30-Sep Trade debtors GL15

675.00

30-Nov Trade debtors GL15

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Purchases

Page 40

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Purchases GL20

700.00

31-Dec Cost of goods sold GL45

950.00

31-Jul Purchases GL20

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Cost of Goods Sold

Page 45

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Inventories GL10

6,900.00

31-Dec Inventories GL10

2,125.00

31-Dec Purchases GL40

950.00

31-Dec Transfer to Income Statement

5,725.00

7,850.00

7,850.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd
Extract of Income Statement for the Year Ended 31 December 2006
Ref

$

Sales GL30

7,825.00

A

Cost of Goods Sold or Cost of Sales:
Opening Inventories GL45

– 6,900.00

B

Purchases GL45

– 950.00

C

Closing Inventories GL45

2,125.00

D

– 5,725.00

E = B+C-D

Gross Profit

2,100.00

F = A+E

An important point to note is for the Periodic Method of recording inventories or stocks, the Cost of Goods Sold or Cost of Sales has three components i.e. the opening inventories, the purchases during the year and also the closing inventories. This is also the formula of Cost of Goods Sold or Cost of Sales: –

Cost of Goods Sold/Cost of Sales = Opening Inventories + Purchases – Closing Inventories

Refer to Table 1, you could actually calculate the Cost of Goods Sold or Cost of Sales by multiplying the Quantity of Stock Out with the respective unit cost of the inventories as follows:-

Table 2

Stock Type A

Stock Type B

Stock Type C

Grand Total

A

B

C = A x B

D

E

F = D x E

G

H

I = G x H

J = C + F + I

Qty

Unit Cost

Total

Qty

Unit Cost

Total

Qty

Unit Cost

Total

$

$

$

$

$

$

$

Stock out:
15.1.06

-50

5.00

-250.00

-250.00

21.3.06

-300

7.00

-2,100.00

-2,100.00

30.9.06

-75

5.00

-375.00

-375.00

30.11.06

-150

20.00

-3,000.00

-3,000.00

TOTAL

-625.00

-2,100.00

-3,000.00

-5,725.00

2. The Perpetual Method

Under the Perpetual Method of recording inventories, the movement of inventories during the financial period is updated regularly to the inventories account in the General Ledger. As a result of this kind of regular updates, more time and effort is required if compared with the Period Method of recording inventories. Refer to the same transactions shown in Example 1, the journal entries required using the Perpetual method of recording inventories are as follows: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006
Trade debtors

400

Sales

400

(Sales for January 2006)
Cost of goods sold

250

Inventories

250

(Being cost of goods sold for January 2006)

c. 20 January 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 January 2006

Inventories

700

Trade creditors

700

(Purchases for January 2006)

d. 21 March 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 March 2006
Trade debtors

3,000

Sales

3,000

(Sales for March 2006)
Cost of goods sold

2,100

Inventories

2,100

(Being cost of goods sold for March 2006)

e. 31 July 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

31 July 2006

Inventories

250

Trade creditors

250

(Purchases for July 2006)

f. 30 September 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 September 2006
Trade debtors

675

Sales

675

(Sales for September 2006)
Cost of goods sold

375

Inventories

375

(Being cost of goods sold for September 2006)

g. 30 November 2006

Balance Sheet

Income Statement

DR

CR

DR

CR

30 November 2006

Trade debtors

3,750

Sales

3,750

(Sales for November 2006)

Cost of goods sold

3,000

Inventories

3,000

(Being cost of goods sold for November 2006)

If you compare the above journal entries with those under the Periodic Method, the difference is for each sale transaction, the cost of goods sold or cost of sales must also be determined and recorded accordingly. This means, a systematic tracking method of the cost of inventories such as shown in Table 2 must be in place to facilitate monitoring the movement of inventories cost. In addition, the journal entries for transferring opening and closing inventories balances to the Cost of Goods Sold account as in the Periodic Method are not required. You would also notice that when ABC Co. Ltd made purchases of inventories, it was the Inventories account that was debited instead of the Purchases account under the Periodic Method. Should there be no incidence of inventories loss due to pilferage etc., the inventories account balance in the General Ledger would reflect the correct balance of closing inventories. The explanation on how stock losses are recorded and reflected will be done in other posts later. The obvious advantage of having a Perpetual Method of recording inventories over the Periodic Method is that those business entities using Perpetual Method are able to know the inventories balance at any point in time.

The relevant accounts in the General Ledger using Perpetual method of recording inventories are as follows: –

ABC Co. Ltd

Page 10

General Ledger

Inventories

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
01-Jan Balance B/F

6,900.00

31-Jan Cost of goods sold GL45

250.00

31-Jan Trade creditors GL20

700.00

31-Mar Cost of goods sold GL45

2,100.00

31-Jul Trade creditors GL20

250.00

30-Sep Cost of goods sold GL45

375.00

30-Nov Cost of goods sold GL45

3,000.00

31-Dec Balance C/F

2,125.00

7,850.00

7,850.00

ABC Co. Ltd

General Ledger

Trade Debtors

Page 15

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Sales GL30

400.00

31-Dec Balance C/F

7,825.00

31-Mar Sales GL30

3,000.00

30-Sep Sales GL30

675.00

30-Nov Sales GL30

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Trade Creditors

Page 20

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Balance C/F

950.00

31-Jan Inventories GL10

700.00

31-Jul Inventories GL10

250.00

950.00

950.00

ABC Co. Ltd

General Ledger

Sales

Page 30

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Dec Transfer to Income Statement

7,825.00

31-Jan Trade debtors GL15

400.00

31-Mar Trade debtors GL15

3,000.00

30-Sep Trade debtors GL15

675.00

30-Nov Trade debtors GL15

3,750.00

7,825.00

7,825.00

ABC Co. Ltd

General Ledger

Cost of Goods Sold

Page 45

DEBIT

CREDIT

Date Descriptions Folio

$

Date Descriptions Folio

$

2006 2006
31-Jan Inventories GL10

250.00

31-Dec Transfer to Income Statement

5,725.00

31-Mar Inventories GL10

2,100.00

30-Sep Inventories GL10

375.00

30-Nov Inventories GL10

3,000.00

5,725.00

5,725.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd

Extract of Income Statement for the Year Ended 31 December 2006

Ref

$

Sales GL30

7,825.00

A

Cost of Goods Sold or Cost of Sales: GL45

– 5,725.00

B

Gross Profit

2,100.00

C = A + B

As you can see, there is no purchases account created under the Perpetual Method.

Inventories or Stocks – Part 1, Introduction

 

Inventories or stocks are one type of assets to many business entities. Inventories or stocks could be in the form of trading goods/merchandise for those business entities principally engaged in purchasing the goods from suppliers and resell those goods to the customers. For a typical manufacturer, inventories or stocks could be in the form of raw materials used in the manufacturing process. Other than raw materials, inventories or stocks could also be in the form of unfinished products called work-in-progress or they could also be in the form of finished goods/products that are ready for sale to the customers.

For many business entities that engaged mainly in providing services, all the tangible inventories mentioned earlier simply are not applicable because these businesses provide services to the customers as major source of revenue or income. However, for some business entities engaged in development of houses, land held for subsequent development into houses are another type of inventory or stock and obviously those unsold houses on hand are the finished products available for sale and therefore are inventories or stocks to the business entities concerned. Any other type of inventories or stocks can you think of? What about livestock and those agricultural produce? As long as these items are meant to be sold to the customers on a “regular” basis with a view to make profit, they are all inventories or stocks to the business entities concerned. What about those items such as office stationery (pens, pencils, papers & etc)? To a stationery distributor or retailer, these are inventories or stocks. However, for many other small businesses whereby the stationery purchased are of the nature of frequently used office supplies, the amount involved normally is insignificant and is therefore normally treated as expenses.

Inventories or stocks are assets to business entities. In other words, they must be valuable to these business entities and in this context, some form of sacrifice (e.g. money spent or in rare cases exchange with other type of assets) must have been made to acquire them. For a typical trading goods merchandiser, inventories or stocks would come into his/her possession when purchases of these goods are made from the suppliers.

The Income Statement

 

Remember in my previous post on the Balance Sheet? The Balance Sheet shows the “position” of an entity at a certain point in time. However, the Income Statement shows a different picture than the Balance Sheet – Income Statement or Profit and Loss Accounts is used to match the income/revenue generated by an entity with all the expenses/costs/losses the entity incurred over a specific period of time, normally this is done yearly to arrive at the final outcome, i.e. the Profit for the year/period. Examples of transactions that have an effect on the Income Statement are as follows:- 

3. Purchase from trade creditor

Assume ABC Co. Ltd purchase goods worth $2,500 from its supplier, Top Goods Co. Ltd on credit term of 30 days. The double entry to record this transaction is as follows: –

 

Balance Sheet

Income Statement

 

Dr

Cr

Dr

Cr

Dr Purchases

 

 

$2,500

 

Cr Trade Creditor

 

$2,500

 

 

 

Assume the Balance Sheet of ABC Co. Ltd. BEFORE this transaction is as per Example 2 of my post, “the Balance Sheet”, the impact of this purchase transaction of $2,500 on the Balance Sheet and the Income Statement is as follows:-

 

ABC Co. Limited

 

Balance Sheet as at 31 December 2006

 

 BEFORE

Impact of this purchase transaction of $2,500

 AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Assets

 

 

 

 

Computer desk

500

 

 

500

Cash at bank

10,000

 

 

10,000

 

10,500

 

 

10,500

Liabilities

 

 

 

 

Trade creditor-Top Goods Co. Ltd

 

 

2,500

 (2,500)

Creditor-Mr X

(500)

 

 

(500)

 

 

 

 

(3,000)

TOTAL (Assets – Liabilities)

10,000

 

 

7,500

Owners’ Equity

 

 

 

 

Paid-up share capital

10,000

 

 

10,000

Accumulated loss

 

2,500

 

(2,500)

TOTAL

10,000

 

 

7,500

 

   
   

 

ABC Co. Limited

 

Income Statement for the year ended 31 December 2006

 

 BEFORE

Impact of this purchase transaction of $2,500

 AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Sales

 

 

Cost of Sales:-

 

 

 

Purchases

2,500

 

(2,500)

 

 

 

 

 

Other income

 

 

Other expenses

 

 

Loss for the year

 

 

(2,500)

 

 

 

 

 

 

Please take note of the following points:-

  • As there were no transactions affecting the Income Statement before this purchase transaction, all the items in the Income Statement have nil value.
  • As there was no other income statement transactions during the year ended 31 December 2006 (the meaning is-the relevant period that we are talking about here is from 1 January 2006 to 31 December 2006) except this $2,500 purchase of goods, the loss for the year is therefore $2,500.
  • The loss for the year of $2,500 would be reflected as Accumulated Loss in the Balance Sheet
  • The impact of this $2,500 purchase transaction MUST be recorded in pair i.e. one Debit (to the Accumulated Loss in this example) and one Credit (to the Trade Creditor-Top Goods Co. Ltd. in this example) to the Balance Sheet. This is the RULE of Double Entry system in accounting! It applies to ALL transactions, except for those transactions affecting items within the Income Statement e.g. reclassifying one type of expense/income to another type of expense/income or setting off an expense item with an income item (e.g. cash discounts against sales).
  • When you compare the Balance Sheet “Before” and “After” this $2,500 transaction, you would notice that Trade Creditor-Top Goods Co. Ltd and Accumulated Loss which both show the same amount of $2,500 are the “Impact” or “Changes”. In other words, the “Impact” or “Changes” in the Accumulated Loss (Retained earnings/profits if the entity is making profits) account in the Balance Sheet is the NET RESULT comparing the Balance Sheet between two different points in time and the complete details of this NET RESULT are shown in the Income Statement!

4. Recognition of Closing Inventories or Stock

Logically speaking, by making a purchase of $2,500 but unable to sell the goods would result in what we call inventories or closing stock in hand. In other worlds, the Balance Sheet and Income Statement shown in Example 3 above are incomplete without recording the recognition of closing inventories!

After ABC Co. Ltd. made a purchase of $2,500 from Top Goods Co. Ltd but unable to sell these batch of goods to its customer, ABC Co. Ltd would need to recognise closing inventories of $2,500 before finished preparing its Balance Sheet and Income Statement by the following double entry:-

 

Balance Sheet

Income Statement

 

Dr

Cr

Dr

Cr

Dr Inventories

$2,500

 

 

 

Cr Cost of sales-Closing Inventories

 

 

 

 $2,500

 

The Balance Sheet and Income Statement of ABC Co. Ltd showing the impact of both the purchase of goods from Top Goods Co Ltd. and recognition of closing inventories are as follows:-

  

ABC Co. Limited

 

Balance Sheet as at 31 December 2006

 

   BEFORE

Impact of $2,500 purchase transaction and recognition of closing inventories

   AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Assets

 

 

 

 

Computer desk

500

 

 

500

Inventories

 

2,500

 

2,500

Cash at bank

10,000

 

 

10,000

 

10,500

 

 

13,000

Liabilities

 

 

 

 

Trade creditor-Top Goods Co. Ltd

 

 

2,500

 (2,500)

Creditor-Mr X

(500)

 

 

(500)

 

 

 

 

(3,000)

TOTAL (Assets – Liabilities)

10,000

 

 

10,000

Owners’ Equity

 

 

 

 

Paid-up share capital

10,000

 

 

10,000

Retained profit/(Accumulated loss)

 

2,500

2,500

TOTAL

10,000

 

 

10,000

 

 

ABC Co. Limited

 

Income Statement for the year ended 31 December 2006

 

   BEFORE

Impact of $2,500 purchase transaction and recognition of closing inventories

   AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Sales

 

 

Cost of Sales:-

 

 

 

Opening inventories

 

 

Purchases

2,500

 

(2,500)

Closing inventories

 

 

2,500

2,500

 

 

 

 

Other income

 

 

Other expenses

 

 

Profit/(Loss) for the year

 

 

 

 

 

 

 

 

Can you see the differences by comparing the Balance Sheet and Income Statement of ABC Co. Ltd in Example 3 and Example 4. Omission of recognising the closing inventories after adjusting the purchases at year end is still a common mistake that I noticed in my auditing assignments to date!

 

More Examples

5. Sale of goods to customer

Assume ABC Co. Ltd sells goods worth $3,000 to a customer subsequent to 31 December 2006, let’s say on 3 of March 2007, Mr Y. The double entry to record this transaction is:-

 

Balance Sheet

Income Statement

 

Dr

Cr

Dr

Cr

Dr Trade debtor-Mr Y

$3,000

 

 

 

Cr Sales

 

 

 

$3,000

 

Let’s consider transaction in Example 6 below before ABC Co. Ltd closes its books for the year ended 31 December 2007 (meaning is to end its financial period and prepare a complete set of final accounts which includes the Balance Sheet and the Income Statement for the financial year ended 31 December 2007) and show the Balance Sheet and Income Statement after this sale of goods transaction.

6. Collections from debtors

 ABC Co. Ltd received a cheque of $3,000 from Mr Y on 21 May 2007 and subsequently deposited the cheque into ABC Co. Ltd’s bank account. The double entry to record this transaction is as follow: –

 

Balance Sheet

Income Statement

 

Dr

Cr

Dr

Cr

Dr Cash at bank

$3,000

 

 

 

Cr Trade debtor-Mr Y

 

$3,000

 

 

Before ABC Co. Ltd. closes its books and prepares the Balance Sheet and Income Statement for the year ended 31 December 2007, the following double entry is required to be made to recognise the opening inventories for the year ended 31 December 2007:

 

Balance Sheet

Income Statement

 

Dr

Cr

Dr

Cr

Dr Cost of sales-Opening Inventories

 

 

 $2,500

 

Cr Inventories

 

$2,500

 

 

 

The Balance Sheet and Income Statement of ABC Co. Ltd. after taking into account these 3 transactions (Sale of goods, Collection from debtor and Recognition of Opening Inventories) are as follows:-

ABC Co. Limited

 

Balance Sheet as at 31 December 2007

 

   BEFORE

Impact of the 3 double entries in Example 5 & 6

   AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Assets

 

 

 

 

Computer desk

500

 

 

500

Inventories

2,500

 

2,500

Trade debtor-Mr Y

3,000

3,000

Cash at bank

10,000

3,000

 

13,000

 

13,000

 

 

13,500

Liabilities

 

 

 

 

Trade creditor-Top Goods Co. Ltd

 (2,500)

 

  

 (2,500)

Creditor-Mr X

(500)

 

 

(500)

 

(3,000)

 

 

(3,000)

TOTAL (Assets – Liabilities)

10,000

 

 

10,500

Owners’ Equity

 

 

 

 

Paid-up share capital

10,000

 

 

10,000

Retained profit/(Accumulated loss)

 

 

 500

TOTAL

10,000

 

 

10,500

 

 

ABC Co. Limited

 

Income Statement for the year ended 31 December 2007

 

   BEFORE

Impact of $3,000 sale transaction and recognition of opening inventories

   AFTER

 

 

Dr

Cr

 

 

$

 

 

$

Sales

 

3,000

3,000

Cost of Sales:-

 

 

 

Opening inventories

2,500

 

(2,500)

Purchases

 

 

Closing inventories

 

 

 

 

 

 

 

(2,500)

Other income

 

 

Other expenses

 

 

Profit/(Loss) for the year

 

 

500

 

 

 

 

 

 

The Balance Sheet

 

As discussed in my earlier posts, the balance sheet shows the financial position of an entity. In addition to the example introduced earlier whereby the owner contributed $10,000 cash at bank as capital (please refer to my post titled Debits and Credits), there are many more examples of transactions that have an impact on the balance sheet, i.e. they would change the items and figures reflected in the balance sheet. Some of the examples are as follows:-

1. Purchase of asset using cash at bank (by way of issuing cheque)

Using the example of ABC Limited in which the owner have contributed $10,000 cash at bank as capital, assume the owner decided to use part of the money to purchase an asset e.g. a computer desk costing $500, the double entry would be as follow:-

Dr. Computer desk                                $500

Cr. Cash at bank                                             $500

After the transaction has been effected, the balance sheet of ABC Co. Limited would show:-

ABC Co. Limited

Balance Sheet as at 31 December 2006

 

$

Assets

 

Computer desk

500

Cash at bank

9,500

Liabilities

TOTAL

10,000

Owners’ Equity

 

Paid-up share capital

10,000

TOTAL

10,000

 

As you can see here, $500 cash at bank used to purchase the computer desk is now recorded as a new asset item called “Computer desk” and as a result, the money left in the bank has reduced from $10,000 to $9,500. Take note that this transaction has NO EFFECT on the Owners’ Equity nor its Liabilities. In other words this is a transaction that affects the assets of ABC Co. Limited.

2. Purchase of asset under credit

Refer to the example of ABC Co. Ltd again, assume this time instead of purchasing the $500 computer desk using the money in the bank, the Owner of ABC Co. Ltd purchased it under credit, i.e. ABC Co. Ltd owes the creditor (Mr X, the computer desk vendor) $500 until it is paid. The double entry would be as follow:-

Dr. Computer desk                                $500

Cr. Creditor-Mr X                                   $500

After the transaction is effected, the balance sheet would show:-

ABC Co. Limited

Balance Sheet as at 31 December 2006

 

$

Assets

 

Computer desk

500

Cash at bank

10,000

 

10,500

Liabilities

 

Creditor-Mr X

(500)

TOTAL (Assets – Liabilities)

10,000

Owners’ Equity

 

Paid-up share capital

10,000

TOTAL

10,000

 

Same as Example 1, a new asset, “Computer desk” is created. In addition, a new liability item, “Creditor-Mr X” is also created. Again this is a transaction that has NO EFFECT on Owners’ Equity. However, it is a transaction that has an effect on Asset (Computer desk) and Liability (Creditor-Mr X).

Please take note that not all transactions affect only the Balance Sheet, there are transactions that have their effect on the Income Statement or Profit and Loss Account as well which I will discuss in later topics.

Debits and Credits

 

These two words are typical to the world of accounting and they relate to the Accounting Equation: –

Assets = Liabilities + Owners’ Equity

Under what we called double entry system in accounting, each transaction must be recorded TWO times. For example, when you as an owner of an entity you contribute capital to the business by opening a bank account lets say $10,000, the following entry is made: –

Dr. Cash at bank                $10,000 (Asset)

Cr. Paid-up share capital      $10,000 (Owners’ Equity)

Note: Dr. represents “debit” and Cr. represents “credit”

Points to note: –

1. All assets item when recorded initially, you must follow the convention of “debiting” the account relating to that particular asset.

2. All liabilities item and Owners’ Equity item on the other hand you must “credit” the relevant accounts relating to that item when you first recognise them.

Refer to the above example, if right after you have contributed the capital to the business and there are no further transactions till the end of the financial year (this is the last day of the period that you wish to set as the financial period for your business entity, 12 months is the full financial period in a year) say 31 December 2006, the Balance Sheet of your business as at 31 December 2006 looks like this: –

ABC Co. Limited

Balance Sheet as at 31 December 2006

 

$

Assets

 

Cash at bank

10,000

TOTAL

10,000

 

 

Liabilities

 

 

Owners’ Equity

 

Paid-up share capital

10,000

TOTAL

10,000

 

The above balance sheet shows the financial position of ABC Co. Limited as at 31 December 2006 i.e. on this date, the entity has $10,000 worth of asset, cash at bank to be specific, which is financed or represented by the $10,000 of paid-up share capital contributed by its owner. Can you see that with the figures included, the Accounting Equation has now become meaningful? Of course in this example, the entity has no liabilities.