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Ascertainment of Cost of Goods Sold. Trading account : Direct Incomes/Expenses

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Valuation of Assets » Direct Expenses

 
 

• Asset Valuation Principle

The value of an asset includes all the expenses incurred before bringing the asset into usable condition.

• Direct Expenditure

In financial accounting, we use the term Direct Expense in relation to assets.

Any expenditure that goes into the value of an asset is identified as Direct Expenditure for that asset.

• Assets » Treatment of Direct Expenses

All the expenses incurred in relation to an asset before bringing the asset into usable condition would form direct expenses for the asset

All the direct expenses in relation to an asset are to be made part of the value of the asset i.e. are to be capitalised.

» Example

If a machine is purchased at Delhi and brought to Tenali for use, then all the expenses incurred before bringing the machine into working mode (usable condition) like transportation charges from Delhi to Tenali, Unloading Charges at Tenali, Installation Charges etc., should be considered to be part of the value of the machine.

These expenses should not be debited to the respective expenditure accounts, but should be debited to the Machinery a/c. The Machinery a/c balance which indicates the value of the asset would be the sum of the cost of the machine, the transportation charges, unloading charges, installations charges, etc..

Is Stock an Asset?

 
 

• Dual nature of Stock

» Purchases : During the Accounting Period

Whenever we purchase stock/goods we debit the Purchases a/c (Nominal account). This implies that we treat the amount spent on purchasing stock as an expenditure.

Such a treatment is adopted all throughout the year.

» Asset : At the end of the Accounting Period

At the end of the accounting period, while preparing the final accounts we treat stock an asset and show it in the Balance Sheet on the assets side.

Thus we can say that stock has dual nature. All throughout the year the amount spent on it is expenditure and only for the moment the balance sheet is prepared it is an asset.

• Valuation of Stock » Based on the Principle for Valuation of Assets

Since Stock is an asset, its valuation should also be made based on the principle for valuation of assets.

The value of stock should include all the expenses incurred before bringing stock into usable condition.

• Usable Condition for Stock » Being ready for Sale

Considering the Stock used in sale, the usable condition for stock would mean getting it ready for sale i.e. it being finally set up in the show case or sale area.

• Value of Stock

All the expenses incurred on the stock till it is placed in the sales area would form direct expenses for the stock and should be treated as a part of the value of stock.

In situations where it would be difficult/impossible to collect all the expenses in detail, this idea is modified to mean the expenses incurred before that stage till which point it would be convenient to collect information.

Direct Expenses for Stock used in Trading Business

 
 
In relation to a trading business, the stock used for sale would be an asset.

The usable condition for that stock would be, it being placed ready for sale in the showroom.

Therefore, the direct expenses in relation to this stock would be all the expenses incurred before placing it in the show room or any other relevant place ready for sale.

Conventionally, expenses like Wages, Carriage Inwards (carriage on purchases), Octroi, Excise, Duties etc., Stock purchased, etc. are treated as direct expenses apart from the actual cost of the goods purchased which is revealed by the "Purchases a/c".

It is not a rule that only these form direct expenses. Any expenditure that would have been incurred in relation to stock before it is made ready for sale would form direct expenditure for the stock.

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Cost of Goods Sold

 
 

• Cost of Goods Sold = Value of the Goods Sold

The cost of goods sold is a term used to indicate the value of the goods sold.

This value is needed to identify the amount of basic/core (gross) profit made by the organisation

» Gross Profit = Sales − Cost of Goods Sold

» Illustrative Explanation

Consider the following data relating to an organisation.
  1. Opening Stock at the beginning of the accounting period, Rs. 20,000.
  2. Purchases of goods/stock during the accounting period : Rs. 2,48,000.
  3. Direct expenses incurred :Rs. 54,000.
  4. Unsold stock at the end of the accounting period valued at Rs. 36,000.
  5. Value of Stock used for other purposes Rs. 14,000.

Particulars Amount Amount
Opening Stock
(+) a) Purchases (Cost Value)
     b) Direct Expenses
Total Value of Goods
(−) a) Closing Stock (Value)
     b) Stock Unused for Trading
Cost of Goods Sold

2,48,000
  54,000

  36,000
  14,000
20,000

3,02,000
3,22,000

  50,000
2,72,000

The formula for calculating the value of Cost of Goods Sold based on the above calculations can be written as

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses
− Closing Stock − Stock Unused for trading

• Stock Unused for Trading

Stock with the organisation may have been used for purposes other than trading. The value of such stock unused for trading purposes has to be deducted from the total value of stock so as to arrive at the value of cost of goods sold.

Some such instances

  • Goods being taken away by the proprietor for personal purposes;
  • Stock used in building up an asset;
  • Stock used for advertisement purposes;
  • Normal loss of stock;
  • Abnormal loss of stock;
  • Stock used up for other types of businesses (like consignments, branches, joint ventures etc)

Do we need Cost of Goods Sold to find Gross Profit

 
 

• Gross Profit = Sales − Cost of Goods Sold

By definition Gross Profit = Sales − Cost of Goods Sold   ← (1)
⇒ To obtain the value of gross profit we need the figures of cost of goods sold and sales.

• Bypassing finding Cost of Goods Sold

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Unused for trading

Substituting this in (1) we get,
• Gross Profit = Sales − (Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Unused for trading)
= Sales − Opening Stock − Purchases − Direct Expenses + Closing Stock + Stock Unused for trading
= (Sales + Closing Stock + Stock Unused for trading) − (Opening Stock + Purchases + Direct Expenses)

Thus we do not specifically need to calculate the value of cost of goods sold for finding gross profit, only its affect is to be brought into account.

Such an ascertainment of Gross Profit is done in the Trading and Profit and Loss account.

DrTrading a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Opening Stock
To Purchases
To Direct Expenses


By Sales
By Stock Unused
By Closing Stock


       

  • "Purchases a/c" is a nominal account with a debit balance and is a direct expenditure (for stock).

    Since Purchases a/c is closed by transfer to the Trading a/c, it appears on the debit side of Trading a/c.

    Transferring a debit balance from one account to a second results in the second account being debited and the first account being credited.

    Thus, all the accounts representing the figures that are added to purchases appear on the debit side

  • "Sales a/c" is a nominal account with a credit balance and is a direct income.

    Since Sales a/c is closed by transfer to the Trading a/c, it appears on the credit side of Trading a/c.

    Transferring a credit balance from one account to a second results in the second account being credited and the first account being debited.

    Thus, all the accounts representing the figures that are added to sales appear on the credit side

» Finding Cost of Goods Sold in such cases

Cost of goods sold is a figure that is not straight away available in the books of accounts used in financial accounting. That figure can be obtained either from the "Trading a/c" or by preparing a separate ledger account to specific account which gives the information relating to the cost of goods sold.

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Ascertaining Cost of Goods Sold from Trading a/c

 
 
Each ledger account serves one or more informational needs of the organisation. The Trading a/c gives the information relating to the Gross Profit made by the organisation. It can also be used to derive the information relating to the "Cost of Goods Sold".

» Ascertaining Cost of Goods Sold

Cost of Goods Sold = (Opening Stock + Purchases + Direct Expenses) − (Closing Stock + Stock Unused for trading)

The "Trading a/c" with this information posted to it would be

DrTrading a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Opening Stock
To Purchases
To Direct Expenses
20,000
2,48,000
54,000
By Closing Stock
By Stock Unused
36,000
14,000
sub-total 3,22,000 sub-total 50,000
       

The trading account before crediting sales would have a greater total on the debit side and thus has a debit balance. That debit balance represents the cost of goods sold.

Thus, to ascertain the cost of goods sold, we need to balance the "Trading a/c" without crediting sales.

The Sales a/c can be subsequently transferred to the Trading a/c to ascertain the Gross Profit.

DrTrading a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Opening Stock
To Purchases
To Direct Expenses
20,000
2,48,000
54,000
By Closing Stock
By Goods Unused
By Cost of Goods Sold c/d
36,000
14,000
2,72,000
  3,22,000   3,22,000
To Cost of Goods Sold b/d
To Gross Profit
2,72,000
1,08,000
By Sales 3,80,000
  3,80,000   3,80,000

If such a two stage Trading a/c is prepared, we would be able to ascertain the Cost of Goods Sold as well as Gross Profit from the Trading a/c itself.

» Ascertaining Cost of Goods Sold by Mathematical Calculations

The Trading a/c is generally prepared only as a single stage account as follows

DrTrading a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Opening Stock
To Purchases
To Direct Expenses
To Gross Profit
20,000
2,48,000
54,000
1,08,000
By Sales
By Goods Unused
By Closing Stock
3,80,000
14,000
36,000
  4,30,000   4,30,000

To obtain the value of cost of goods sold from this we use the definition for gross profit.

• Cost of Goods Sold = Sales − Gross Profit [Since Gross Profit = Sales − Cost of Goods Sold]
= Rs. 3,80,000 − Rs. 1,08,000
= Rs. 2,72,000

Finding Cost of Goods Sold using Goods Consumed a/c

 
 
The value of Cost of Goods Sold can also be obtained specifically, by maintaining a separate account for the purpose. This may be named "Goods Consumed a/c" (any other indicative name may be used).

The basic purpose of accounting is derivation of information and the more the information we need, the more the accounting heads we need to maintain.

The Goods Consumed a/c is nothing but the first part of the trading account where it was balanced twice.

DrGoods Consumed a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Opening Stock
To Purchases
To Direct Expenses
20,000
2,48,000
54,000
By Goods Unused
By Closing Stock
By Trading a/c
14,000
36,000
2,72,000
  3,22,000   3,22,000

The balance in the Goods Consumed a/c represents Cost of Goods sold. This account is closed by transferring the balance to the Trading a/c.

DrTrading a/cCr
Particulars Amount
(in Rs)
Particulars Amount
(in Rs)
To Goods Consumed
To Gross Profit
2,72,000
1,08,000
By Sales 3,80,000
  3,80,000   3,80,000

• Cost of Goods Consumed

If the balances in the ledger accounts representing direct expenses are not transferred to the "Goods Consumed a/c" but are transferred to the "Trading a/c", then the balance from the "Goods Consumed a/c" cannot be called cost of goods sold (value of goods sold).

It just represents the cost of goods consumed. To obtain the cost of goods sold from this, the direct expenses have to be added to this.

Goods used within the Organisation have to be valued at Cost

 
 
The stock that is used within the organisation (stock drawn by the proprietor for own purposes, stock used for building an asset, stock used for advertisement purposes, etc.,) have to be valued at cost.

This is for the reason that if such usages are recorded at a value which includes an element of profit, the transaction when recorded would generate a profit, which would amount to making a profit out of a transaction with oneself.

Principle of Mutuality » One cannot make a profit out of a transaction with oneself

» Illustrative Explanation

Consider the following data relating to an organisation which started its operations on 28th December 2006:
  • Opening Stock :: Nil;
  • Purchases :: Rs. 1,20,000;
  • Direct Expenses :: Rs. 30,000
  • Sales :: Nil
  • Stock used by the organisation internally Rs. 20,000 (Valued at Cost).
    Generally Sales are made by adding 25% profit to cost
  • Closing Stock :: ?

The accounting period ends on 31st December 2006.

Value of Closing Stock with the Organisation = Total Value of Stock − Value of Stock used up internally
= Purchases + Direct Expenses − Rs. 20,000
= (Rs. 1,20,000 + Rs. 30,000) − Rs. 20,000
= Rs. 1,30,000

Sales value of the stock used within the organisation = Cost + 25% of Cost
= Rs. 20,000 + 25% of Rs. 20,000
= Rs. 20,000 + Rs. 5,000
= Rs. 25,000

• Stock used up internally recorded at Sales Value

DrTrading a/cCr
Particulars Amount
(in Rs)
Amount
(in Rs)
Particulars Amount
(in Rs)
Amount
(in Rs)
To Purchases
To Direct Exp.
To Gross Profit

1,20,000
30,000
5,000
 
By Sales
By Stock used
By Closing Stock


25,000
1,30,000
    1,55,000     1,55,000

There is no commercial activity (no sales), there is no scope for earning profits. But the Trading a/c reveals a Gross Profit of Rs. 5,000 which is on account of the stock used up internally being recorded at sales value.

Such profit generation is inappropriate for the reason that in using up stock within the organisation, the organisation is not conducting a transaction with an outside party.

Thus to avoid profit generation in such cases, the stocks so used are to be valued at cost.

• Stock used up internally recorded at Cost

DrTrading a/cCr
Particulars Amount
(in Rs)
Amount
(in Rs)
Particulars Amount
(in Rs)
Amount
(in Rs)
To Purchases
To Direct Exp.
To Gross Profit

1,20,000
30,000
Nil
 
By Sales
By Stock used
By Closing Stock


20,000
1,30,000
    1,50,000     1,50,000

The Trading a/c would reveal no profit when the stock used up internally is valued at cost.

Author Credit : The Edifier ... Continued Page 11

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