Accounting treatment of sales and purchases (final accounts -scenario 1)

The aspect of sales and purchases need to be well understood by the entrepreneur/ learner before engaging on the accounting treatment of the same. Sales is gain/gross income an organization generates during its ordinary trading activities. The learner need to note that, not all sales components qualifies to be recorded in the trading account. This is because when a company is being established, the promoters are expected by the registrar of companies or the concerned government arm of that country to prepare a memorandum of association which comprise five elements, namely; name clause, capital clause, location clause, liability clause and object clause.

My focus is on object clause which requires one to state the main objective of establishing the firm. This objective becomes the basis of the ordinary activities of the organization. Therefore, if a firm was formed to buy and sell farm cereals, then the sales income will comprise of sell of cereals. Also, if a firm was established to deal with provision of medical services, then its sales component will be from the ordinary activity of providing medical services to its clients. Similarly, purchase cost considered in the trading account based on the revenues aforementioned, will be cost of purchasing cereals and direct cost associated with facilitation of medical services. These two components of trading account are referred to as trading income and trading expenses respectively. Therefore, when establishing the gross profit or loss of the firm, the two types of trading income and expenses are compared by determining the difference between the two anyway. In addition, it is the unsold components of this items that form the opening and closing inventory.

It is with this accounting knowledge, that we need to conclude that, if a firm was established to deal with buying and selling of merchandise such as motor vehicles or office equipment as its ordinary activities, then in preparation of trading accounts at the end of the financial period such components form sales and purchases components to be incorporated. It is the same components which forms part of closing inventory if not yet sold at the end of the financial period. Recall the concept of capital and revenue expenditure in level one accounting tutorial series. (the learner can re-visit the concept in level one tutorial materials). Hence, it is the objective clause which governs the entrepreneur or the learner on where to categorize the sales and purchases components but not the size of the good acquired. However, a firm may also have other incidental objectives other than the main one. Such additional objectives form part of operating income and operating expenses in that order. For instance, an organization could have been formed to deal with acquisition and sale of motor vehicles.

Further, the organization could have invested in other businesses such as rental houses, acting as an agent of another firm or invested in securities such as stocks and bonds. The costs associated with such investments will form its operating expense and the income generated thereof will be operating income. It is fair to note that when preparing the final accounts, we match the trading incomes with trading expenses and similarly with compare operating income with operating expenses in that order, otherwise we will be breaching the matching concept if we mix them. In illustration 1, we will first deal with a case of trading perspective. That is income and expenses of trading nature whereby the aspect of the relationship between quantity and monetary perspective of sales and purchases is given preeminence as follows;

Illustration

Assume Our Co. ltd purchased and sold stock in cash from January to December of year 2018 as portrayed in the summary below

Relationship between Sales and Purchases of a Business

Required

i). Determine the gross profit/loss at the end of the year 31/12/18

ii) Extract the balance sheet as per that same date

Solution

The tutorial has used two approaches to provide solution to this illustration. That is arithmetic and accounting approach. The first approach is applicable to entrepreneurs who have little knowledge in accounting and the second approach is used to help the entrepreneur to appreciate the role of accounting techniques used in determining business profit/loss. Before we consider the two approaches, we will first internalize the matter as follows; that the total units and cost of inventory/goods purchased for the twelve months (one financial period) was 1070 (quantity) and $107,000 respectively. At the same time, the total units sold within the twelve months (one financial period) was 1070 (quantity) and $267,500 in that order. Therefore, when determining the gross profit of the business, the matching principle advocates that we consider income (ie sales) and expenses of the same period of time (12 months). In this case, it is fair to consider the units of inventory bought and sold within that period for there are cases of opening and closing stock which would have a mismatch implications if not factored in the computation of profit/loss. This scenario one has assumed that all units purchased were all sold. Therefore, the difference between the total sales and total purchases cost is;

Arithmetic Approach

    Gross Profit=Sales-Cost of Goods Sold. That is;

    GP= 267,500 (1070 units sold)- 107,000 (1070 units purchased)

             = 160,500

Accounting Approach

NB1: Remember that the purchases and sales accounts have DR and CR totals respectively and to prepare the trading account for Our Co. ltd, those accounts has to be closed down to trading account. So the entrepreneur/learner should note that preparation of trading account is not a mere listing of the relevant items as it apparently appears but it entails application of double entry principle.

NB2: That in the trading account, the business gain computed is referred to as gross profit. However, when preparing the balance sheet, we consider net profit. This is because there were no operating expenses to further charge against the gross profit given. When this is the case, the gross profit is treated as the net profit.

NB3: Both arithmetic and accounting approaches are the same for we were able to arrive at the same gross profit figure. Again, in scenario one, it is assumed that all units purchased were all sold. However, this coincidence is not common most of the times, even if the business is new in its operations, the probability of having some closing inventory units is high. So the question is, in such a case where closing inventory is available, should this business match the purchase cost for all units of merchandise/goods bought against sales value of the units actually sold? Definitely no. The entrepreneur or the learner need to factor in only the cost of goods sold. This takes us to scenario two so as to establish how to treat a case of closing inventory.