Various Types of Transactions – Collection from Other Source of Revenue and Income (Part 4)

As mentioned in my post: Various Types of Transactions – Part 1, Introduction, there were 5 examples of other source of revenue or income highlighted – interest income, dividend income, rental income, proceeds from disposal of assets and compensation received for loss of assets. Please take note that this is not an exhaustive list as there are more types of other source of revenue and income not mentioned. For the purpose of easy understanding and simplicity, I will only discuss these 5 different other source of revenue and income in the following posts:-

Various Types of Transactions – Collection from Sales or Services Rendered (Part 3)

For profit orientated entities, revenue is the “bloodline” of the businesses. The cash collected from invoicing or billing is vital in keeping the businesses up and running – meeting all sorts of daily expenses. Depending on the nature of the businesses, the sales invoices or bills issued to customers are for the sale of goods or services rendered. Generally the invoices or bills issued could be on cash term (pay on delivery of goods or services performed) or on credit term (e.g. 30 days, 60 days, 90 days etc). I have discussed in length the day book used in recording sales, the sales ledger and posting to the relevant accounts in the general ledger. The double entry for recording both the cash sales and credit sales are shown below:

Cash Sales

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Sales

XXXX

Credit Sales

a. Upon Recognition of Revenue

Balance Sheet

Income Statement

DR

CR

DR

CR

Trade debtors

XXXX

Sales

XXXX

b. Upon Receiving Payments from Trade Debtors

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Trade debtors

XXXX

The recording of collection from sales or services rendered usually is a straight forward matter. The “grey area” or issue involved usually is associated with when revenue should be recognised. This is because different industries have their own unique ways of conducting the businesses. As stated in the Objective Section of International Accounting Standard (IAS) 18: Revenue, revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measure reliably.

For a typical business selling goods to its customers, the point of recognising revenue usually is at the point when the substantial risks and rewards associated with the goods have been transferred to its customers – usually when goods is delivered to and accepted by its customers. IAS 18 states the criteria of recognising revenue from sale of goods as follows: –

Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) the amount of revenue can be measured reliably;

(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and

(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

For a typical business rendering services to its customers, recognition of revenue is depending on the stage of completion of the services at the measurement point (at the balance sheet date – it could be the end of the month or the end of the year depending on the financial period determined by the entity). Stage of completion is referring to at the measurement point, the percentage of the services completed. For example, if the percentage of completion is 50% and $100,000 is to be invoiced to the customer when the job is completed, $50,000 would be recognised as revenue. Please take note that the cost associated with the revenue should also be recognised using the same percentage of completion method. IAS 18 states the criteria of recognising revenue from services rendered as follows: –

When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

(a) the amount of revenue can be measured reliably;

(b) it is probable that the economic benefits associated with the transaction will flow to the entity;

(c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and

(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Many small businesses rendering services to their customers would find it very challenging to comply with the requirements of recognising revenue and the costs by way of percentage of completion method. This is because this requires a detailed tracking mechanism of the costs of each job and also the stage of completion throughout the life of each project/job. Some countries may have set their own requirement as to the application of accounting standards by giving exemption to “small entities” in respect of using percentage of completion method in recognising the revenue and costs. If this is the case, revenue and costs would usually be recognised using the completed contract method – i.e. the revenue and the relevant costs would be deferred from being recognised in the income statement until when the job is completed.

I will not discuss in detail the requirements of IAS 18 here as this article is just meant to be an introduction to the recording of revenue. If you are interested to know more about the issues involved regarding revenue, please refer to IAS 18. Appendix 1 of IAS 18 shows examples of different type of sales transactions including “Bill and Hold” sales, goods shipped subject to conditions, lay away sales under which the goods are delivered only when the buyer makes the final payment in a series of instalments, installation fees, servicing fees included in the price of the product, advertising commissions & etc. that are worth reading.

Various Types of Transactions – Contribution of Capital from Owners (Part 2)

When owners inject cash into businesses as capital, the double entry to record this type of transactions is: –

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Capital

XXXX

Cash injections could be done by way of contributing “hard cash”. If this is the case, the asset account debited is the Petty Cash account. Cash injections could also be done by way of the owners issue cheques. If this is the case, the asset account debited is the Cash at Bank account. Usually, if the amount involved is huge, cheques are issued instead of hard cash.

Following the rule of double entry recording system, whenever there is a debit entry made to an account (the Petty Cash of Cash at Bank account in this illustration), there must also be a credit entry made to an account (the Capital account in this illustration).

Please refer to Debits And Credits and The Accounting Equation if you need further explanations on double entry recording system and the accounting equation. If you need explanation on the difference between balance sheet and income statement, please refer to The Balance Sheet and The Income Statement .

For sole proprietorships and partnerships, the account to be credited whenever there are capital injections is called the “Capital Account”. Please take note that for many sole proprietorships and partnerships (especially for partnerships), there could be another account called “Current Account” maintained to record those transactions between the business and the partners such as profit attributable to each partner during the year, salary, interest on capital contributions, drawings OTHER THAN the capital transactions. Please refer to my post: Three Most Common Types of Small Businesses for an example of income statement and balance sheet of a partnership. Do not be confused with the current account opened with banking institutions. They are different. Capital Accounts and Current Accounts are maintained for each partner to show the capital position of each partner and their other dealings with the business.

For sole proprietorships, the importance of maintaining a separate Capital Account and Current account is not as apparent if compared to that of partnerships because all the transactions recorded in the Capital Account and the Current Account are attributable to only one person i.e. the owner. You may have come across many instances of the balance sheets prepared for sole proprietors with no separate Capital Account and Current Account maintained. In this case, all the transactions in the Capital Account and Current Account are recorded in one single account named “Capital Account”. Example of the equity section of the balance sheet of a sole proprietor using this method of recording is as follows: –

Capital:

$

Balance at beginning of year

5,178

Add: Additional capital injections during the year

15,000

Add: Profit for the year

3,152

Less: Net drawings during the year

(8,000)

Balance as at end of year

15,330

Some partnerships may choose this method of recording. However, the drawback is that there is no ready information available on how much is the accumulated capital amount that has been contributed by each partner. There could also be situations whereby the net drawings of some partners exceeded the capital amount that they have contributed and nobody realise this!

For private limited companies, whenever there are capital injections, the account to be credited is called “Share Capital Account”. Some call it “Paid-up Share Capital Account”. This is because there could be instances of unpaid capital by shareholders. I will explain this in another topic. The main difference if compared with the balance sheet of sole proprietorships or partnerships is no separate current account maintained. Any withdrawal or advance of money to private limited companies by shareholders are recorded separately in the balance sheet account called Amount due by Shareholder (current asset) or Amount due to Shareholder (current liability) depending on whether it is the Company who owe the shareholder money or the other way round. The amount owing usually is classified as current asset or current liability because the nature of the transactions is short term in nature. Even though there are instances where the amount due to or due by shareholders remained unpaid/unsettled for more than a year because there was no repayment fixed in the first place, it is deemed to be repayable on demand and is therefore classified as current asset or current liability.

Please take note that it may not be a straight forward matter for a company to give or obtain loan or advances from shareholders or in fact any other parties because it is the board of directors that has the power to manage the business of the company and make decisions on the company’s behalf – Not the shareholders. A shareholder may not sit on the board of directors and even though he or she does in fact sit on the board of directors, the decision making power lies with the board of directors, not on individual directors. Therefore, in making a decision whether the company should give or receive advance or loan from any party including shareholders, the board of directors has a duty to ensure that it is done on the basis that the company’s best interest is taken care of. It should also be noted that shareholders are not “powerless” entirely. They usually are given the power in the articles of association of the company such as to elect directors, set their remuneration in members’ annual general meetings and also on matters that would alter the capital of the company.

Various Types of Transactions – Introduction (Part 1)

It is easier to understand the basic principles and concepts of accounting once you are familiar with the types of transactions that a typical business entity has to deal with. There is no better place to start with knowing what kind of receipts a typical business receives and also the type of payments made. Even though numerous transactions nowadays are done on credit, eventually the amount owed is expected to be settled or paid.

Receipts

Generally, the receipt transactions of a typical business include the following:-

· Contribution of capital from owners

· Collection from sales or services rendered (cash sales or payments received from trade debtors). This is usually the major source of revenue or income of the business entity

· Collection from other source of revenue or income:-

o Interest income

This is earned through deposits placement with financial institutions. Sometimes, it is also earned through lending of money to third parties (Some countries have strict laws governing money lending activities) o Dividend income

This is earned through investment of shares in another company. It is a return on investment made.

o Rental income

This is earned through the letting of its assets (property, machinery, equipment & etc).

o Proceeds from disposal of assets

These are in respect of the money received as a result of the disposal of property, machinery, equipment & etc.

o Compensation received for loss of assets

Compensation received from insurance companies for stolen or damaged assets.

· Disbursement/Release of principal sum of loans or borrowings from third parties (usually financial institutions)

· Refund of deposits placed earlier with third parties

o E.g. The refund of rental and utility deposits upon termination of rental of premises.

Payments

Generally, they are for the following purposes: –

· For the inventories/stocks and related costs in which those inventories or stocks are meant for subsequent sale. (Generally all of these are called inventory costs)

· For capital expenditure.

· For revenue expenditure.

· For tax on the profits generated (due to income tax law requirements)

· For distribution of profits back to the owners in the form of dividends

· Sometimes as short term advance of money or loan to other entities ( it could be individuals including the owners, directors, employees or non-individuals such as companies who have business dealing with it)

· Of course on the other hand, it could be for repayment of loan or short term advance include interest for the money the business entities had borrowed earlier

· For refundable deposits of money paid to third parties or prepayment of capital and revenue expenditure

· Payment for investment in shares

· Deposit of money with financial institutions

· In less frequent instances, return of capital back to the owners

I will discuss the above one by one in my subsequent posts. However I am going to discuss briefly here on the double entries involved for the above transactions.

Receipts

For all receipt transactions above, if the transactions were in cash or cheques, the debit entry must be made to the petty cash or cash at bank account. The question here is – what should be the credit entry? Which account? Is it a credit to an income statement item account or to a balance sheet item account?

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank/Petty Cash

XXXX

?

?

?

Payments

On the other hand, if the transactions were in cash or cheques, the credit entry must be made to the petty cash or cash at bank account. The question is – what should be the debit entry? Which account? Is it a debit to an income statement item account or a debit to a balance sheet item account?

Balance Sheet

Income Statement

DR

CR

DR

CR

?

?

?

Cash at bank/Petty Cash

XXXX

Cash Basis Vs Accrual Basis of Accounting

Many small businesses use cash basis of accounting to record transactions, especially those who prepare the accounts once a year. Please refer to my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid for further illustrations.

Indications that cash basis of accounting is used includes the following:-

  • No books of original entry such as sales day book and purchases day book used to record sales and purchases.
  • No debtors ledger or creditors ledger maintained.
  • All receipts and payments are recorded directly in cash book.

Cash basis of recording transactions and presenting the financial statements produced has long been deemed an inappropriate basis to use. Accrual basis of accounting is the accepted basis and this is stated in International Accounting Standard (IAS) 1: Presentation of Financial Statements.

It is good if a business entity is aware of the difference between cash basis and accrual basis of accounting and records its transactions using accrual basis. However, for those businesses who have recorded the transactions using cash basis do not need to discard those set of accounts produced and record all past transactions using accrual basis of accounting all over again. What need to be done is re-examine all the account items that have been produced using cash basis of accounting to determine as to whether any adjustment is required to adjust those items should accrual basis of accounting is used. Some examples: –

  1. Sale of goods

    Under cash basis of accounting, all proceeds collected from sales are recorded in the accounting records upon receiving payments from customers. The balance sheets produced using cash basis of accounting do not show any trade debtor balances! Those sales figures shown in the income statements represent only cash sales. No credit sales are recorded.

    The solution is to identify all bills and invoices of those sales in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid sales invoices or bills and put through a journal adjustment to recognise the credit sales and trade debtors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Trade debtors

    XXXX

    Sales

    XXXX

    A point to note on the criteria used to determine the occurrence of transactions (sales recognition in this case) is usually based on delivery and acceptance of goods by customers. You may have come across the solution because I have discussed this in Step 4a, The Worst Case Scenario of my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid.

  2. Purchase of goods

    This is the opposite of sales of goods discussed above. Similarly, the balance sheets produced under cash basis of accounting will not show any trade creditor balances. The purchases figures shown in the income statements represent only cash purchases. No credit purchases are recorded.

    The solution is the same as discussed in sale of goods above. You need to identify all unpaid bills and invoices in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid purchase invoices or bills and put through a journal adjustment to recognise the credit purchases and trade creditors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Purchases

    XXXX

    Trade Creditors

    XXXX

  3. Prepayments
  4. Some expenses are paid now but part of them or the entire sums are meant for future period. This is the reason that they are called “Prepayments”. Under cash basis of accounting, prepayments are usually recorded as the respective expense accounts. What is required here is an adjustment to recognise the prepayments as current assets i.e. those portion of the payments that are meant for the next financial year.

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Expenses

    XXXX

    Cash at bank

    XXXX

    Adjustment for prepayments recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    XXXX

    Expenses

    XXXX

    Example

    The financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 November 2007, ABC Co. Ltd. paid the insurance premium for its fire policy covering the period from 1 December 2007 to 30 November 2008. The amount paid was $2,400. The prepayment for insurance is therefore $2,200 ($2,400/12 months x 11 months for the period from 1 January 2008 to 30 November 2008).

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Insurance premium

    2,400

    Cash at bank

    2,400

    Adjustment for prepayment recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    2,200

    Insurance premium

    2,200

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for prepayment recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

– 90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

2,356

2,356
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-2,400

2,200 – 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-66,296

– 64,096
Net profit for the year

4,455

6,655
Retained profits B/F

27,654

27,654
Retained profits C/F

32,109

34,309
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Sundry receivables

1,058

1,058
Deposits

2,000

2,000
Prepayments

2,200 2,200
Amount due by shareholders

13,375

13,375
Cash and bank balances

10,639

10,639

38,272

40,472
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-2,575

– 2,575

-6,163

– 6,163
Net current assets

32,109

34,309

47,109

49,309
Financed by: –
Share capital

15,000

15,000
Retained profits

32,109

34,309

47,109

49,309
  1. Interest income

    Business entities may place excess cash as term deposits with financial institutions to earn interest income. Under cash basis of accounting, there was no interest income recognised and recorded in the accounts until the business entities receive the interest upon maturity of the term deposits.

    However, under accrual basis of accounting, the amount of interest attributable to the relevant period of the deposits placement must be calculated and recognised accordingly. For examples, the financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 July 2007, ABC Co. Ltd. placed $100,000 with its bank as term deposit for 1 year. The interest rate is 3.5% per annum. The interest earned from 1 July 2007 to 30 June 2008 is $350 ($100,000 x 3.5%). In respect for the accounts of ABC Co. Ltd. for the year ended 31 December 2007, the portion of the interest income to be recognised is $175 ($350 x 6months/12months for the period from 1 January 2007 to 31 December 2007).

    The journal adjustment to recognise this interest income is as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Interest receivable

    175

    Interest income

    175

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for interest income recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

-90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-64,096

– 64,096
Net profit for the year

4,299

4,474

Retained profits B/F

27,654

27,654
Retained profits C/F

31,953

32,128
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Interest receivable

175 175
Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000
Cash and bank balances

10,639

10,639

138,116

138,291
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

– 106,163

– 106,163
Net current assets

31,953

32,128

46,953

47,128
Financed by: –
Share capital

15,000

15,000
Retained profits

31,953

32,128

46,953

47,128

On 30 June 2008, when the deposit matures and interest of $350 is received by ABC Co. Ltd., the double entry to record these transactions is as follows:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

100,350

Fixed deposit with licensed bank

100,000

Interest receivable

175

Interest income

175

The balance sheet and income statement of ABC Co. Ltd. for the year ended 31 December 2008 before and after this adjustment are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2008

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

109,270

109,270
Cost of Sales

– 40,875

– 40,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

– 800

– 800
Depreciation of property, plant and equipment

– 2,500

– 2,500
Donation

– 500

– 500
Electricity & water

– 3,340

– 3,340
Insurance premium

– 200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

– 12,000

– 12,000
Salaries

– 27,865

– 27,865
Upkeep of office

– 3,547

– 3,547
Telephone charges

– 1,285

– 1,285
Travelling, petrol & toll charges

– 2,648

– 2,648

– 56,382

– 56,382
Net profit for the year

12,013

12,188
Retained profits B/F

27,654

27,654
Retained profits C/F

39,667

39,842
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

10,000

10,000
Current assets
Inventories

5,000

5,000
Trade receivables

17,030

17,030
Other receivables, deposits & prepayments:
Interest receivable

175

175

Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000

Cash and bank balances

12,348

100,350 112,698

150,830

151,005
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

-106,163

– 106,163
Net current assets

44,667

44,842

54,667

54,842

Financed by: –
Share capital

15,000

15,000

Retained profits

39,667

39,842

54,667

54,842

Out of the $350 interest received, $175 was credited to the interest receivable account and $175 is credited to the interest income account for the year ended 31 December 2008 (for the interest earned for the period from 1 January 2008 to 31 December 2008.

The interest was calculated based on simple interest method. For illustrations on the difference between simple interest and compound interest, please refer to my post: Effective Interest? Simple Interest? Compound Interest? Nominal Interest?

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.