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I read from a study text that “the purchase represents a cost (or an expense) to the business; this cost will reduce the profits of the business which in turn reduce the equity in the business”.
I think this is wrong because goods purchased are assets (not expenses) until they are sold. So profits of the business (and the equity in the business) will not decrease when goods are purchased on credit. The dual effect will be: asset (inventory) increases and liability (trade creditor) increases. Am I correct?The purchase itself is an expense.
However any of the goods that are unsold are inventory and inventory left over reduces the next expense in the Statement of profit or loss, and appears as an asset in the Statement of financial position.To see how the entries work, you should watch my free lecture here on inventory.
Thank you so much but you haven’t answered my question. I’d like to know the dual effect of a typical transaction, which is credit purchase of goods.
There are two different answers:
A. equity decreases and liability increases
B. asset increases and liability decreasesWhich answer is correct, A or B?
And if the correct answer is A, can you explain why asset does not increase? Inventory (unsold goods) is an asset, isn’t it?
Yes – I did answer your question!
Purchases is an expense of the business – so it decreases the profit (and hence the equity) and if it is on credit then it increases the liability.
Separately, if any of the purchases are unsold then we have inventory.
If we have inventory then this is an asset so assets increase and profit (so equity) also increases. (It has no effect on liabilities).The two things are separate. Purchases are an expense, inventory left over is an asset.
I assume that you have watched my lecture? If so you will see that we only account for any asset of unsold inventory at the end of the period.
Thank you for your reply.
I found the answer to my question in your F3 free lecture (chapter 2 part a). When you (is that you?) talked about the dual effect of a transaction (transaction d: buys goods for resale on credit), you said the inventory has gone up (asset increases) and the business owes an amount to the person we bought the goods from (liability increases). That’s the answer I want.
What I don’t understand is that why treat goods bought as expenses in the first place and when we find that the goods are unsold at the end of the period we change them back to asset. I just want to say that purchase of goods (per se) will not decrease the profit (or equity). If we follow the wrong concept (i.e. purchase decreases the profit and the equity), we may draw very strange conclusion. e.g. purchases returns will increase the profit (we can return goods to suppliers to make profit???), drawings of goods will not decrease equity (Is that true?)
Thank you.
I have given you the answer twice, and I repeat it!
A purchase of goods for resale is an expense precisely because we will be selling them – it is an expense of the sale.
The only reason for dealing with inventory at the end of the period is to make sure that the expense is charged in the period in which the sale is made. They are only temporarily an asset.If we buy goods for 10,000 and sell half this year and half next year, then there is still an expense of 10,000. It is simply that we charge half the expense against this years sales and the other half of the expense against next years sales.
My example in chapter 2 is to explain the nature of the Statement of financial position, and the Statement of profit or loss (Income statement). Temporarily during the example there is an asset of inventory, but if you follow it through to the end, all the purchases become an expense (because there is no inventory at the end of the period).
Purchases of goods for resale will always decrease the profit – whether it is this period or next period (if some of them are carried forward in inventory).
And of course purchase returns will increase the profit – there is nothing strange about that at all. If we return goods then the net expense is reduced.
With regard to drawings of goods, although the drawings themselves decrease capital, there is no overall effect on the capital at all. (Incidentally, it is only called equity if it is a limited company – the taking of goods by the owner is only relevant for a sole trader where it is capital, not equity).
Consider this: suppose the business buys goods for 20,000 and sells them for 30,000. There is a profit of 10,000 and capital therefore increases by 10,000.
However, suppose it turns out that the owner took goods that had cost 1,000. In this case there are certainly drawings of 1,000 (and this reduces the capital). However since the cost of the goods that were sold are now only 9,000, it means that the profit is actually 11,000 – 1,000 higher than before, which increases the capital).Can I suggest again that you watch the lecture on inventory. The first part of it explains and illustrates the entries for dealing with inventory at the end of the period.
Thank you for giving me a detailed answer. My two examples are used to demonstrate that acceptance of a wrong concept will lead to a strange (or absurd) result.
First, let me repeat what I said in my first post: “goods purchased are assets (not expenses) until they are sold”. When inventories (goods purchased) are SOLD, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. The keyword here is “SOLD”.
Some people get purchases and cost of goods sold mixed up. The cost of goods sold is an expense but purchases may not be the same as cost of goods sold. Consider the following formula: (to keep things simple, let’s ignore opening inventory for the moment)
cost of goods sold = purchases – closing inventory
It is very strange or even absurd if purchase returns will increase the profit. If this is true, a trader can return goods to the suppliers to increase the profit. There is no need to sell goods at a price higher than the cost to make profit. In fact, if we return goods then the net PURCHASE is reduced but the cost of goods sold remains unchanged. Why? Because the closing inventory is also reduced by the same amount as goods returned. And from the above formula, it is not difficult to see why the cost the goods sold (and hence the profit) is the same. In other words, we cannot increase the profit by just returning goods. This makes sense.
Some may argue that when all goods purchased are sold, there is no inventory. In this case, purchases will be the same as cost of goods sold. Let’s consider my second example. I will use the figures given by you for illustration purpose.
“Consider this: suppose the business buys goods for 20,000 and sells them for 30,000. There is a profit of 10,000 and capital therefore increases by 10,000.
However, suppose it turns out that the owner took goods that had cost 1,000. In this case there are certainly drawings of 1,000 (and this reduces the capital). However since the cost of the goods that were sold are now only 9,000, it means that the profit is actually 11,000 – 1,000 higher than before, which increases the capital).”There is a careless mistake in the last sentence. I assume that you mean the cost of the goods that were sold are now only 19,000 (not 9,000). So you said “the profit is actually 11,000 – 1,000 higher than before, which increases the capital”. This is also incorrect. Why? It may be easier to understand if we assume 20 units of goods are bought at 1,000 each. So the total cost is 20,000 and the unit selling price is 1,500. If the owner took goods that had cost 1,000 (i.e. one unit), the cost of goods that were sold are now 19,000. But the sales revenue is not 30,000 any more because there are only 19 units of goods available for sale. That means the sales revenue is 19 x 1,500 = 28,500 only and therefore the profit is 28500 – 19000 = 9500 (not 1,000 higher but 500 lower than before). So in addition to a decrease in capital because of drawings, the business earns 500 less. (one unit of goods is taken by the owner and the related profit is forgone.)
I hope my explanation is clear. Thank you again for your attention.
You are now being stubborn and pedantic 🙂
First the reason that returning goods means more profit it pure logic – if you buy goods for 1000 and sell them for 1500 then there is a profit of 500.
Is you had returned 100 of the goods and still sold the remaining goods for 1500, then the cost of the goods sold is 900 and the profit is 600.
Purchases are an expense of selling the goods, returns reduce the expense.Yes – I had made a careless mistake – but the rest of what I wrote was correct. If sales for the period are $30,000 then they are $30,000. The profit is the difference between the sales and the cost of sales.
I do suggest you move on and waste no more time on a pedantic point. Purchases are an expense. Dealing with inventory at the end of the period is a way of charging the expense as the sales are made, and at the same time producing the ‘temporary’ asset in the Statement of financial position.
(And do watch the lecture on Inventory!)
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