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.

The Accounting Equation

 

You can find a lot of materials on-line about what accounting is about and you will not miss them mentioning The Accounting Equation: –

ASSETS = LIABILITIES + OWNERS’ EQUITY

Assets are simply those things that are valuable to an entity and they include items such as the equipment bought and used in business, the trade receivables, cash kept at banks, inventories & etc. Generally, the entity must have some form of control over these items and enjoy the benefits that these items would bring to the entity. It is easier to understand the meaning of benefits to the owner if you could picture that by using the assets in your business, they would help generate the sales/revenue which is important to a profit orientated entity. (Mmm… leave your thoughts on profit to later discussions – How well an entity manage/use the assets and also the liabilities will have an outcome on the profit to be generated by the entity)

An entity does not own an asset out of nothing (Remember the old phrase – there is no free lunch in this world?). Yes, either you pay for it using your own money (i.e. Owners’ Equity) OR if you don’t have any money, borrow (i.e. Liabilities). Yes, that is the meaning of the accounting equation – All the assets of an entity must equal to the sum of all the liabilities plus the owners’ contributions to the business! Simple right? If you stick to this formula in recording EACH and EVERY transaction of an entity over a period of time, you would get a set of accounts in which the outcome of is what we call a BALANCE SHEET (Some refer to this as a Statement of Assets and Liabilities) and INCOME STATEMENT (Some refer to this as a Profit and Loss Account), which we will discuss in later topics.