Effective Interest? Simple Interest? Compound Interest? Nominal Interest?

Simple interest is usually discussed and compared with compound interest. Simple interest is named as such because the interest calculated is not compounded.

In contrast, when compound interest is calculated, nominal interest rate and effective interest rate would be the relevant interest rates involved in the calculations or discussions.

Example

  1. Simple Interest

    ABC Co Ltd. placed $100,000 deposit with Bank A for 1 year with interest of 3.5% per annum and calculated on simple interest method.

    Interest earned at the end of the one year period is therefore calculated as follows: –

    $100,000 x 3.5%

    = $3,500

  2. Compound Interest

    In the context of compound interest calculation, you need to specify the following: –

    1. The total length of the placement of deposit. In this example, one year.
    2. The frequency of compound interest calculation. E.g. daily, monthly, quarterly & etc.
    3. The nominal annual rate of interest used.

    Assume monthly compounding of interest is adopted, with 3.5% nominal annual rate of interest, we usually say:

    “ABC Co Ltd. placed $100,000 deposit with Bank A for 1 year with 3.5% nominal annual rate of interest monthly compounding”.

    The interest earned is calculated as follows:-

    FV = PV x (1 + i)n

    Where,

    FV = future value of the deposit (the total value of the $100,000 deposit at the end of the 1 year period.)

    PV = the present value of the deposit (the value of the deposit at the beginning of the 1 year period, which is $100,000)

    n = the number of period in terms of compounding. For example, if the period of the deposit placement is 2 years with monthly compounding, n = 24 ( 2years x 12)

    i = the interest rate in percent per period of compounding. In this example, i =0.29667% (3.5%/12). Word of caution here, when you do the calculation, i is 0.00296667. Many make mistake in the calculation because they did not realise that i is expressed in percentage!

    Therefore, for this $100,000 deposit placement,

    FV = $100,000 (1 + 3.5%/12)12

    = $103,556.70

    The interest earned is therefore $3,556,70 ($103,556.70 – $100,000)

    Conclusion

    On $100,000 deposit placement, interest at 3.5% per annum monthly compounding for 1 year period will yield an extra $56.70 compared to 3.5% per annum simple interest method.

    There could be instances whereby ABC Co Ltd. is offered different options for deposit placement with Bank A. For example:-

    Option 1

    $100,000 1 year at 3.5% per annum monthly compounding

    Option 2

    $100,000 2 years at 4.75% per annum quarterly compounding

    Option 3

    $100,000 5 years at 4.80% per annum yearly compounding

    How does ABC Co Ltd. evaluate these options? Which is the best option? As the period of the investment i.e. the length of the placement is different (Option 1 = 1 year; Option 2 = 2 years; Option 3 = 5 years), a meaningful comparison on “level field” is desired – using Effective Interest Rate.

    The formula for effective interest rate is:-

    R = (1 + i)n – 1

    Where,

    R = the effective interest rate

    i = the interest rate in percent per period of compounding

    n
    = the number of period in terms of compounding in a year

    Option 1

    R = (1 + 3.5%/12)12 – 1

    = 3.56%

    Option 2

    R = (1 + 4.75%/4)4 – 1

    = 4.84%

    Option 3

    R = (1 + 4.80%/1)1 – 1

    = 4.80%

    Based on the effective interest rates calculated for the three options, Option 2 gives the highest rate and appears to the best. However, in making the selection ABC Co Ltd. should also consider other factors including the future plan of ABC Co Ltd. in terms of when will the money is needed in future & etc. in one year? 3 years? 5 years?

    How much will ABC Co Ltd earn for each option?

    Option 1

    FV = $100,000 (1 + 3.5%/12)12

    = $103,556.70

    Interest earned at the end of 1 year placement is $3,556.70 ($103,556.70 – $100,000)

    Option 2

    FV = $100,000 (1 + 4.75%/4)8

    = $109,904.36

    Interest earned at the end of 2 years placement is $9,904.36 ($109,904.36 – $100,000). But take note that this is over 2 years if you compare to that of Option 1. If you calculate using straight-line time proportion basis, Option 2 gives $4,952.18 ($9,904.36 divided by 2 years) and appears to yield much higher interest. Straight-line time proportion basis does not give a good picture for the comparison because the interest is compounded. Using the effective interest method, the FV under Option 2 at the end of Year 1 is: –

    FV = $100,000 (1 + 4.75%/4)4

    = $104,835.28

    The interest earned for Year 1 under Option 2 is therefore $4,835.28 ($104,835.28 – $100,000) and not $4,952.18 calculated under the straight-line time proportion method.

    The interest earned during Year 2 under Option 2 is: –

    FV = $104,835.28 (1 + 4.75%/4)4

    = $109,940.36

    The interest earned for Year 2 is therefore 5,069.08 ($109,940.36 – $104,835.28).

    Perform a summation proof by adding the interest earned in Year 1 and Year 2:-

    Total interest (Year 1 + Year 2) = $4,835.28 + $5,069.08

    = $9,904.36!

    Option 3

    FV = $100,000 (1 + 4.80%/1)5

    = $126,417.17

    Interest earned at the end of 5 years placement is $26,417.27 ($126,417.17 – $100,000). But take note that this is over 5 years if you compare to that of Option 1 or Option 2. If you calculate using straight-line time proportion basis, Option 5 gives $5,283.54 ($26,417.27 divided by 5 years) and appears to yield much higher interest. Straight-line time proportion basis does not give a good picture for the comparison because the interest is compounded. Using the effective interest method, the FV under Option 3 at the end of Year 1 is: –

    FV = $100,000 (1 + 4.80%/1)1

    = $104,800

    The interest earned for Year 1 under Option 2 is therefore $4,800 ($104,800 – $100,000) and not $5,283.54 calculated under the straight-line time proportion method.

    The interest earned during Year 2 under Option 3 is: –

    FV = $104,800 (1 + 4.80%/1)1

    = $109,830.40

    The interest earned for Year 2 is therefore 5,030.40 ($109.830.40 – $104,800.00).

    The interest earned during Year 3 under Option 3 is: –

    FV = $109,830.40 (1 + 4.80%/1)1

    = $115,102.26

    The interest earned for Year 3 is therefore 5,271.86 ($115,102.26 – $109.830.40).

    The interest earned during Year 4 under Option 3 is: –

    FV = $115,102.26 (1 + 4.80%/1)1

    = $120,627.17

    The interest earned for Year 4 is therefore 5,524.91 ($120,627.17 – $115,102.26).

    The interest earned during Year 5 under Option 3 is: –

    FV = $120,627.17 (1 + 4.80%/1)1

    = $126,417.27

    The interest earned for Year 5 is therefore 5,790.10 ($126,417.27 – $120,627.17).

    Perform a summation proof by adding the interest earned in Year 1,Year 2, Year 3, Year 4 and Year 5:-

    Total interest (Year 1 + Year 2 + Year 3 + Year 4 + Year 5)

    = $4,800 + 5,030.40 + 5,271.86 + 5,524.91 + 5,790.10

    = $26,417.27!

    Note: The excess of 10 cents ($26,417.27 – $26,417.17) is due to rounding error.


Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid

Many small business owners started the businesses on their own or with minimal staff strength. Usually, the major focus of the businesses is on revenue generation and leaves the function of transactions record keeping and accounting to inexperience staff. Many business owners leave it aside until the end of the financial year or when the deadline of accounts submission to the authorities coming close. The accounts and financial statements of the business entities are prepared once a year. Please take note that this practice of recording transactions once a year is definitely not encouraged and may even contravene the law imposed on businesses in some countries with the owners unaware of this. Depending on how the accounting documents are filed and kept, the accounting personnel assigned the task of preparing the accounts and the financial statements once a year may face the following three scenarios: –

First Scenario – The worst case scenario

The owners have little or no knowledge of accounting and transactions record keeping. No accounting records or transaction records listing kept. No separate recording of receipts and payments made. All the accounting documents including receipts, invoices & etc are probably not kept in files and in a mess. Personally, I have seen cases whereby all these source documents were just being thrown into a big box throughout the whole financial year! It puzzles me how these business owners monitor the daily cash flow position of the business operations. Many of them have to rely on constantly checking the bank account balances before payments are made or just relying on the fact that the bank account are allowed to be “overdrawn” because of overdraft facility. However, bank balances obtained from banks at any particular point in time do not necessary provide a reliable bank balances of the business available for use because of unpresented cheques and uncleared deposits. In addition, allowing unnecessary utilisation of overdraft facility is actually a waste of money for the business. This is a nightmare for the accounting personnel!

Steps: –

1. Sorting of documents

The first step is to sort all the accounting documents by types and in chronological order.

2. Identify and recover missing documents

Identify any obvious missing documents and take action to get a copy.

3. Key-in transactions in the accounts

Start with the cheque butts and bank statements by entering transactions into the cash book and the relevant accounts in the general ledger. Since there was no recording of transactions throughout the whole financial year, it serves little purpose now if you chose to record the transactions the conventional way to the books of original entry (Sales day book, purchase day book & etc) and then posts the transactions to the general ledger. However, it is good if you decide to do it the conventional way.

Important point: Key in or record the transactions MONTH BY MONTH. After the transactions of the first month have been completely recorded, prepare a bank reconciliation statement BEFORE you move on to the next month! This is important because if you proceed straight to key in all the transactions of the whole financial year in one go into the accounts, you still need to ensure that the bank balance reflected in the accounts as at the end of the financial year does in fact tally with the bank balance reflected on the bank statement (To prepare a bank reconciliation statement). Can you imagine what would happen if the reconciliation does throw out unreconciled differences? You have to go through all the transactions for the whole financial year (Both the entries recorded in the cash account and also the transaction entries reflected on the bank statements) and match each and every of them! By keying in transactions month by month and perform bank reconciliation also month by month, you are actually dividing this gigantic task into small parts and definitely much easier to manage and complete!

4. Further Adjustments

After all the entries have been recorded and reconciled to the bank statements, you still need to perform the following tasks before closing all the accounts and proceed to preparing the balance sheet and income statement: –

a. Credit transactions

Identify all bills, and invoices both for sales and purchases in which the transactions have occurred as at THE END OF THE FINANCIAL YEAR, but still have not been settled or paid. Go through all the invoices or bills settled or paid after the financial year and also all the unpaid or unsettled bills or invoices on hand. The criteria to determine the occurrence of transactions is usually based on the delivery and acceptance of goods and completion of services and NOT on the billing date as reflected on the invoice! Once you have completed this task, a listing of trade debtors, trade creditors, other debtors and other creditors should have also been compiled. Use journal entries to record and post these credit transactions in the respective accounts in the general ledger.

b. Year End Inventories or Stock Balance

The financial year end inventory balance is required to be ascertained. Usually, it is a required practice to conduct a year end stock counting exercise, and depending on the type of the business entities, if the financial statements of the business entities are subject to statutory audit requirement, the auditors should be informed of the stock counting date and be invited to observe the stock counting exercise. However, if the transactions record keeping of the business entities is in such a poor state, usually stock counting exercise at year end is also unlikely to have been conducted. Depending on the nature of the business entities, the task of identifying year end stock balances could be taking a lot of time and effort or just a simple and easy task. If the business is a service provider, no stock balances! If the business is selling only one type of goods, it is still fairly easy to identify the stock balance by way of identify the goods that have been purchased during the financial year (especially towards the end of the financial year) and SOLD in the NEXT FINANCIAL YEAR. Also identify those goods purchased during the financial year and remained unsold at the time of preparing the accounts. Of course if the stocks are beyond the usual stock holding period, the reason why the stocks are still unsold and any write down or write off required is the next issue to consider. However, if the business sells many different types of goods and also the volume of the businesses is large, this is a very time consuming task! Once the year end inventories or stock balance is ascertained, use journal entries to record the balance in the accounts.

c. Prepayment and deposits (balance sheet accounts with debit balances)

If all the prepayment and deposits have been calculated accordingly during the stage of keying in transactions into the accounts in the general ledger, it is of course no longer necessary to consider this. However, if there were no effort spend to calculate them before, you would now required to identify the possible prepayments and deposits which have most likely been recorded as expenses in the income statement items account and do the necessary adjustments by way of journal entries to recognise these items as balance sheet items.

5. Closing accounts and prepare trial balance, balance sheet and income statement

Once the above steps have been completed, it is time now to prepare the trial balance, balance sheet and income statement.

Second Scenario – Moderate cases

Accounting documents are filed by types and in chronological order. No cash book maintained but a listing or book that is used to record and describe each receipt and payment is maintained. In a way, this serves the role or cash receipts journal and cash payment journal.In this scenario, Step 1 and 2 described in the First Scenario are not necessary because the transactions record keeping are organised and in order. However, you need to go through the receipts and payments listing and segregate all the transactions into the respective types or groups and compute the total of each type or group of the transactions in accordance with the general ledger accounts items. You just need to post the total of each type or groups of transactions by way of journal entries the cash account and the respective general ledger accounts. Again, this should be performed month by month and also ensure the bank reconciliation is also performed month by month. After this, perform the tasks described in Step 4 and Step 5 of the First Scenario.

Third Scenario – Organised and Good Transactions Record Keeping

Cash book is used to record all receipts and payments and proper columns in the cash book are used to record each type of group of transactions in accordance with the accounts items in the general ledger. In these cases, the total of each column in the cash book is readily available at the end of each month. Most likely the monthly bank reconciliation statements are also prepared. You just need to record the total of each column in the cash book in the general ledger using journal entries. After this, perform the tasks described in Step 4 and Step 5 of the First Scenario.

Dividend Imputation

In some countries, dividends are distributed to shareholders under dividend imputation system. The purpose of this system is to avoid imposing tax “2 times” on the same income is first generated by companies (taxed the first time when the income is reported by companies), which is then distributed to shareholders as dividends (taxed the second time when the dividend income is reported by individual shareholders).

Example

Company A has 2 shareholders – Mr Big and Mr Small, each holding 50% of the shares in Company A. The details of the share capital of Company A are shown below: –

$

Authorised Share Capital:

100,000 ordinary shares or $1.00 each

100,000

Issued and Fully Paid-up Share Capital:

100,000 ordinary shares or $1.00 each

100,000

For the financial year ended 31 December 2007, Company A made $25,000 profit before taxation and declared and paid a dividend of 25 cents per share to its shareholders.

Based on the profit of $25,000, assume a corporate income tax rate of 20%, and there are no adjustments required to be made to the $25,000 accounting profit to arrive at the taxable profit, the corporate income tax paid by Company A is therefore $5,000 ($25,000 x 20%).

The summarised income statement of Company A for the year ended 31 December 2007 is shown below:-

$

Profit before taxation

25,000

Taxation

-5,000

Profit after taxation

20,000

Retained profits brought forward (Assume $10,000)

10,000

Profits available for appropriation

30,000

Dividends

-25,000

Retained profits carried forward

5,000

The $25,000 is the dividend distributed to both Mr Big and Mr Small in the following manner:-

$

Mr Big – 50% 12,500
Mr Small – 50% 12,500
TOTAL 25,000

In a simplified scenario and assuming there is no dividend imputation, both Mr Big and Mr Small would need to declare this dividend received as a source of income to the tax authority and be taxed accordingly. Assuming a personal income tax rate of 10%, and no other source of income, and no other deductions or rebates, Mr Big and Mr Small would need to pay $1,250 each as income tax to the tax authority.

The following table shows clearly that based on the same source of profit, originally the $25,000 profit before taxation made by Company A, and subsequently distributed to the shareholders as dividends – $12,500 to Mr Big and $12,500 to Mr Small, the total amount of income tax collected by the tax authority is $7,500 ($5,000 from Company A, $1,250 from Mr Big and $1,250 from Mr Small):-

$5,000

—–> on $25,000 profit reported by Company A

+

$1,250

—–> on $1,250 profit reported by Mr Big

+

$1,250

—–> on $1,250 profit reported by Mr Small
TOTAL TAX COLLECTED

$7,500

There is an argument that it is unfair for the tax authority to impose tax twice on the same income and therefore the dividend imputation system is introduced.

Under the dividend imputation system, the amount of tax paid by companies, in this example, the $5,000 tax charged on Company A, will be recorded in a tax credit account. This tax credit account is not an account created and maintained in the general ledger, it is just a memorandum account used to keep track of the income tax on companies which can be used to frank the payment of dividends to shareholders.

Based on the $5,000 tax charged on Company A (some countries require that the tax must be paid by companies before it is eligible to be used as tax credit to frank the payment of dividends), and assume it is eligible to be used as tax credit to frank the dividends, Company A would need to perform a calculation check to know the maximum amount of profits that can be distributed to its shareholders, WITHOUT additional tax to be paid as follows:-

Tax credit = $5,000
Maximum amount of profit that Company A can declare as dividend without incurring additional tax
= $5,000 X

(100% – income tax rate)

income tax rate

= $5,000 X

(100% – 20%)

20%

= $5,000 X

80%

20%

= $20,000

This $20,000 represents the profit of Company A that can be distributed as net dividend to that shareholders without paying additional tax and if Company A were to decide to declare its profit to the maximum without paying additional tax, the dividend is usually described as follows: –

“Company A declared and paid a gross dividend of $25,000 less tax of $5,000 (tax rate at 20%) amounted to $20,000 to its shareholders”.

Refer to the summarised income statement of Company A:-

$

Profit before taxation

25,000

> This is NOT the maximum amount of profit that Company A can distribute as dividends without incurring additional tax
Taxation

-5,000

> This is the tax credit available to be utilised to frank the payment of dividends
Profit after taxation

20,000

> This IS the maximum amount of profit that Company A can distribute as dividends without incurring additional tax

Assume now Company decided to declare $20,000 net dividends to its shareholders, instead of $25,000 (as described earlier where there is no dividend imputation)

In the books of Company A

The double entry for the recording of the dividends paid is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Retained profits – dividend*

20,000

Cash at bank

20,000

*Take note that dividend is not an expense. It is a distribution of profits to shareholders and therefore is shown as a deduction against retained profits.

In the books of Mr Big

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

In the books of Mr Small

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

Assume a personal income tax rate of 10% and both Mr Big and Mr Small have no other source of income, no other deductions and rebates, the tax computation prepared for tax purposes is as follows:-

Mr Big Mr Small

$

$

Dividend income

12,500

12,500

A
Tax @ 10%

1,250

1,250

B = A X 10%
Tax credit available for set-off

-2,500

-2,500

C = from the $5,000 tax credit in Company A split into 50% for Mr Big and 50% for Mr Small
Tax recoverable

-1,250

-1,250

D = B + C

As shown above, the $5,000 ($2,500 each for Mr Big and Mr Small) tax credit available for Mr Big and Mr Small to set off against the tax payable calculated on the dividend income, is from the tax credit of Company A on the $25,000 profit reported to the tax authority.

In the hand of the shareholders, Mr Big and Mr Small, as the amount of tax on the dividend income is only $1,250 each for Mr Big and Mr Small, both Mr Big and Mr Small are eligible to apply to the tax authority for the refund of the “excess” tax paid amounted to $1,250 each for Mr Big and Mr Small. This $1,250 of “excess” tax paid is therefore shown as tax recoverable.

The double entry to record the amount of tax payable of $1,250 calculated above is:-

In the books of Mr Big

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

In the books of Mr Small

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

The income statement of Mr Big and Mr Small after taken into account of the two adjustments is as follow:-

Mr Big Mr Small

$

$

Profit before taxation (Assume only dividend income. No other income or expenses)

12,500

12,500

Taxation

-1,250

-1,250

Profit after taxation

11,250

11,250

The extract of the balance sheet of Mr Big and Mr Small showing the tax recoverable is as follow:-

Mr Big Mr Small

$

$

Current Assets
Inventories

xxxx

xxxx

Trade receivables

xxxx

xxxx

Other receivables, deposits and prepayments

xxxx

xxxx

Tax recoverable ($2,500 – $1,250)

1,250

1,250

Cash at bank

xxxx

xxxx

A word of caution, I have seen many mistakes on the recording of dividend income in the books of the recipients when the dividend imputation system is applied. The mistakes done usually is because the following double entry is used to record the dividend income:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Dividend income

10,000

The tax computation prepared is as follows:-

$

Dividend income

10,000

Tax @ 10%

1,000

The journal adjustment to record the tax payable is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,000

Tax payable

1,000

Can you see the mistakes made?

  1. Instead of showing a tax recoverable of $1,250, a tax payable of $1,000 is shown.
  1. Taxation amount shown in the income statement of $1,000 instead of $1,250
  1. The tax of $1,000 not set off against the tax credit of $2,500.
  1. Dividend income shown in the income statement is $10,000 instead of $12,500

What if Company A decided to declare a net dividend of $25,000 to its shareholders?(i.e. $5,000 in excess of the $20,000 calculated where no additional tax liability required). Under the tax law and regulations in respect of dividend imputation, Company A is required to pay the tax on the excess of $5,000 ($25,000 – $20,000) for distributing the profit as dividend to its shareholders, i.e. $1,000 ($5,000 x 20%). I have seen many companies declared and paid dividends to the shareholders in excess of the maximum amount without realising that this is the case and attracted unnecessary tax penalties.

Separate Entity Concept

In accounting, a business entity is treated as a separate entity from the owner(s). Therefore, any capital injections made by the owner(s) are recorded as capital contribution from owners in the books of the business entity. The owner(s)’ private expenditure/spending are not recorded in the books of the business entity.

There are many instances whereby the owner(s) withdrew money from the business for their personal use. This is actually a lending of money from the business to the owner(s) and should be recorded as such in the books of the business entity. On the other hand, when the owner(s) inject cash into the business to help easing tight cash flow situation faced by the business entity, it is a lending of money from the owner(s) to the business and should also be recorded as such in the books of the business entity.

Many owner(s) of small businesses fail to see this “line” drawn between the business and the owner(s). The direct consequence is the recording of private/personal expenditure in the books of the business entities and therefore the financial position and results of the business entities do not show a “true picture” of the business entities. The business entities may face the following problems: –

• Private/personal expenses not adjusted from the profit/income reported for income tax purposes and therefore understating the income subject to tax. Unnecessary penalty and more seriously, jail terms are possible outcome.

• It may cause the application for banking facility unsuccessful should the assessor of the application notice that the owner(s)’ private expenditure is included in the financial statements of the business entities.

• In general, this does not do good to the application submitted by the business entities whereby financial statements are to be included in the application (e.g. project tender, grant application & etc.)
This problem of keeping the books/accounts of business entities “clean” from owner(s)’ private expenditure can be further compounded if the transactions record keeping of the business entities is poor, making any effort to identify these private expenditure recorded in the books of the business entities for adjustment purposes difficult.

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.