Bookkeeping & Accounting All-in-One For Dummies (2015)

Book II

Bookkeeping Day to Day

Chapter 3

Buying and Tracking Your Purchases

In This Chapter

arrow Tracking stock and monitoring costs

arrow Keeping your business supplied

arrow Paying your bills

In order to make money, your business must have something to sell. Whether you sell products or offer services, you have to deal with costs directly related to the goods or services being sold. Those costs primarily come from the purchase or manufacturing of the products you plan to sell or the items you need in order to provide the services.

remember All businesses must keep careful watch over the cost of the products they sell or the services they offer. Ultimately, your business’s profits depend on how well you manage those costs, because in most cases costs increase over time rather than decrease. How often do you find a reduction in the price of needed items? It doesn’t happen often. When costs increase but the price to the customer remains unchanged, the profit you make on each sale is less.

In addition to the costs to produce products or services, every business has additional expenses associated with purchasing supplies needed to run the business. The bookkeeper has primary responsibility for monitoring all these costs and expenses as invoices are paid and alerting business owners or managers when suppliers increase prices. This chapter covers how to track purchases and their costs, manage stock, buy and manage supplies, and pay the bills for the items your business buys.

Keeping Track of Stock

Products to be sold are called stock. As a bookkeeper, you use two accounts to track stock:

·        Purchases: Where you record the actual purchase of goods to be sold. This account is used to calculate the Cost of Goods Sold, which is an item on the Profit and Loss statement (see Book IV, Chapter 1 for more on this statement).

·        Stock: Where you track the value of stock on hand. This value is shown on the Balance Sheet as an asset in a line item called Stock (Book IV, Chapter 2 addresses the Balance Sheet).

Businesses track physical stock on hand using one of two methods:

·        Periodic stock count: Conducting a physical count of the stock in the stores and in the warehouse. This count can be done daily, monthly, yearly or for any other period that best matches your business needs. (Many businesses close for all or part of a day to count stock.)

·        Perpetual stock count: Adjusting stock counts as each sale is made. In order to use this method, you must manage your stock using a computerised accounting system tied into your point of sale (usually cash registers).

·        tip Even if you use a perpetual stock method, periodically do a physical count of stock to ensure that the numbers match what’s in your computer system. Because theft, damage and loss of stock aren’t automatically entered in your computer system, the losses don’t show up until you do a physical count of the stock you have on hand in your business.

When preparing your Profit and Loss statement at the end of an accounting period (whether that period is for a month, a quarter or a year), you need to calculate the Cost of Goods Sold in order to calculate the profit made.

In order to calculate the Cost of Goods Sold, you must first find out how many items of stock were sold. You start with the amount of stock on hand at the beginning of the month (called Opening Stock), as recorded in the Stock account, and add the amount of purchases, as recorded in the Purchases account, to find the Goods Available for Sale. Then you subtract the stock on hand at the end of the month (Closing Stock), which is determined by counting remaining stock.

Here’s how you calculate the number of goods sold:

·        Opening Stock + Purchases = Goods Available for Sale – Closing Stock
                                             = Items Sold

After you determine the number of goods sold, compare that number to the actual number of items the business sold during that accounting period, which is based on sales figures collected through the month. When the numbers don’t match, you’ve a problem. The mistake may be in the stock count, or items may be unaccounted for because someone has misplaced or damaged and discarded them. In the worst-case scenario, you may have a problem with customer or employee theft. These differences are usually tracked within the accounting system in a line item called Stock Shortages.

Entering initial cost

When your business first receives stock, you enter the initial cost of that stock into the bookkeeping system based on the shipment’s invoice. In some cases, invoices are sent separately, and only a delivery note is included in the order. When that situation applies, you still record the receipt of the goods, because the business incurs the cost from the day it receives the goods, and you must be sure that the money is available to pay for the goods when the invoice arrives and the bill comes due. You track outstanding bills in the Trade Creditors (Accounts Payable) account. Where you only have a delivery note, use the price agreed on your purchase order (if you use purchase orders) or the price from your last invoice from that supplier.

Entering the receipt of stock is a relatively easy entry in the bookkeeping system. For example, if your business buys £1,000 of stock to be sold, you normally receive a purchase invoice for those goods. The invoice is entered into your accounting system as described in Book I, Chapter 4. The following double entry takes place:

 

Debit

Credit

Materials Purchased

£1,000

 

Trade Creditors

 

£1,000

The Purchases account increases by £1,000 to reflect the additional costs, and the Trade Creditors account increases by the same amount to reflect the amount of the bill that needs to be paid in the future.

When stock enters your business, in addition to recording the actual costs, you need more detail about what you’ve bought, how much of each item you’ve bought and what each item cost. You also need to track

·        How much stock you have on hand

·        The value of the stock you have on hand

·        When you need to order more stock

Tracking these details for each type of product bought can be a nightmare. However, a computerised accounting system simplifies this process of tracking stock. Details about stock can be entered initially into your computer accounting system in several ways:

·        If you pay by cheque or credit card when you receive the stock, you can enter the details about each item on the cheque counterfoil or credit card slip.

·        If you use purchase orders, you can enter the detail about each item on the purchase order, record receipt of the items when they arrive and update the information when you receive the bill.

·        If you don’t use purchase orders, you can enter the detail about the items when you receive them and update the information when you receive the bill.

To give you an idea of how this information is collected in a computerised accounting software program, Figure 3-1 shows you how to enter the details in Sage 50 Accounts. This particular form is for the receipt of stock without a purchase order and can be used when you receive a supplier invoice.

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Figure 3-1: Recording of the receipt of stock using Sage 50 Accounts.

Figure 3-2 shows a stock item record in the computerised accounting system. Note that you must give the item a product code and a description. The product code is a short unique name or code to identify the stock item internally. The longer description is a more user-friendly name that can appear on customer invoices (sales transactions). You can input a cost and sales price if you want, or you can leave them at zero and enter the cost and sales prices with each transaction.

image

Figure 3-2: Setting up a stock item using Sage 50 Accounts.

tip If you’ve a set contract purchase price or sales price on a stock item, you can enter the price on this form to save time – you don’t then have to enter the price each time you record a transaction. But if the price changes frequently, leave the space blank so that you don’t forget to enter the updated price when you enter a transaction.

Notice in Figure 3-2 that you can also use this form to give you information about stock on hand and when stock needs to be reordered. To make sure that your shelves are never empty, enter a number for each item that indicates at what point you want to reorder stock. You can indicate the ‘Reorder Level’ in the section called ‘Status’. (A nice feature of Sage 50 Accounts is that you can run a report to see which stock items have fallen below their reorder level and use that to place your next order.)

If you use the Purchase Order Processing routine and save the form that records the receipt of stock in Sage 50 Accounts, the software automatically

·        Adjusts the quantity of stock you have in stock

·        Increases the Asset account called Stock

·        Lowers the quantity of items on order (if you initially entered the information as a purchase order)

·        Averages the cost of stock on hand

·        Increases the Trade Creditor account

Managing stock and its value

After you record the receipt of stock, you have the responsibility of managing the stock you have on hand. You must also know the value of that stock. You may think that as long as you know what you paid for the items, the value isn’t difficult to calculate. Well, accountants can’t let things be that simple, and so have five different ways to value stock:

·        LIFO (last in, first out): You assume that the last items put on the shelves (the newest items) are the first items to be sold. Retail shops that sell non-perishable items, such as tools, are likely to use this type of system. For example, when a hardware store gets new hammers, workers probably don’t unload the hammers on the shelves and put the newest items in the back. Instead, they put the new hammers in the front, so they’re likely to be sold first.

·        FIFO (first in, first out): You assume that the first items put on the shelves (the oldest items) are sold first. Shops that sell perishable goods, such as food shops, use this stock valuation method most often. For example, when new milk arrives at a shop, the person stocking the shelves unloads the older milk, puts the new milk at the back of the shelf, and then puts the older milk in front. Each carton of milk (or other perishable item) has a date indicating the last day it can be sold, so food shops always try to sell the oldest stuff first, while those items are still sellable. (They try, but how many times have you reached to the back of a food shelf to find items with the longest shelf life?)

·        Averaging: You average the cost of goods received, to avoid worrying about which items are sold first or last. This method of stock is used most often in any retail or services environment where prices are constantly fluctuating and the business owner finds that an average cost works best for managing the Cost of Goods Sold.

·        Specific identification: You maintain cost figures for each stock item individually. Retail outlets that sell big-ticket items such as cars, which often have a different set of extras on each item, use this type of stock valuation method.

·        LCM (lower of cost or market): You set stock values based on whichever is lower: the amount you paid originally for the stock item (the cost) or the current market value of the item. Businesses that deal in precious metals, commodities or publicly traded securities often use this method because the prices of their products can fluctuate wildly, sometimes even in the same day.

warning After you choose a stock valuation method, you need to use the same method each year on your financial reports and when you file your accounts. If you decide that you want to change the method, you need to explain the reasons for the change both to HM Revenue & Customs and to your financial backers. If you run an incorporated business in which shares have been sold, you need to explain the change to your shareholders. You also have to go back and show how the change in stock method impacts your prior financial reporting, and adjust your profit margins in previous years to reflect the new stock valuation method’s impact on your long-term profit history.

Figuring out the best method for you

We’re sure that you’re wondering why the stock valuation method you use matters so much. The key to the choice is the impact on your bottom line as well as the tax your business pays.

keyconcept Because FIFO assumes the oldest (and most likely the lowest priced) items are sold first, this method results in a lower Cost of Goods Sold number. Because Cost of Goods Sold is subtracted from sales to determine profit, a lower Cost of Goods Sold number produces a higher profit. (For more on Cost of Goods Sold, see ‘Keeping Track of Stock’, earlier in this chapter.)

The opposite is true for LIFO, which uses cost figures based on the last price paid for the stock (and most likely the highest price). Using the LIFO method, the Cost of Goods Sold number is higher, which means a larger sum is subtracted from sales to determine profit. Thus, the profit margin is lower. The good news, however, is that the tax bill is also low.

The Averaging method gives a business the best picture of what’s happening with stock costs and trends. Rather than constantly dealing with the ups and downs of stock costs, this method smoothes out the numbers you use to calculate a business’s profits. Cost of Goods Sold, taxes and profit margins for this method fall between those of LIFO and FIFO. Definitely choose this method when you’re operating a business in which stock prices are constantly going up and down.

The Averaging method always falls between LIFO and FIFO as regards the Cost of Goods Sold, taxes and profit margin.

warning Sage 50 Accounts uses the LIFO method to calculate Cost of Goods Sold and stock line items on its financial reports, so if you choose this method, you can use Sage 50 Accounts and the financial reports it generates. However, if you choose to use one of the other four stock methods, you can’t use the Sage 50 Accounts financial report numbers. Instead, you have to print out a report of purchases and calculate the accurate numbers to use on your financial reports for the Cost of Goods Sold and Stock accounts.

tip Check with your accountant to see which stock method is best for you given the type of business you’re operating and which one is the most acceptable to HM Revenue & Customs. It’s one of many accounting methods that your accountant needs to choose when setting up the stock system. We discuss the various different methods of measuring Cost of Goods Sold in Book V, Chapter 2.

Comparing the methods

To show you how much of an impact stock valuation can have on profit margin, in this section we compare three of the most common methods: FIFO, LIFO and Averaging. In this example, we assume that Business A bought the stock in question at different prices on three different occasions. Opening Stock is valued at £500 (50 items at £10 each).

Here’s the calculation to determine the number of items sold (from the earlier ‘Keeping Track of Stock’ section):

·        Opening Stock + Purchases = Goods Available for Sale – Closing Stock
                                             = Items Sold
                              50 + 500 = 550 – 75
                                             = 475

Here’s what the business paid to purchase the stock:

Date

Quantity

Unit Price

1 April

150

£10

15 April

150

£25

30 April

200

£30

Here’s an example of how you calculate the Cost of Goods Sold using the Averaging method:

Category

Quantity (Unit Price)

Total Cost

Opening Stock

50 (£10)

£500

Purchases

150 (£10)

£1,500

 

150 (£25)

£3,750

 

200 (£30)

£6,000

Total Stock

550

£11,750

Now you can do other calculations:

Average Stock cost

£11,750 ÷ 550 = £21.360

Cost of Goods Sold

475 × £21.36 = £10,146

Closing Stock

75 @ £21.36 = £1,602

remember The Cost of Goods Sold number appears on the Profit and Loss statement and is subtracted from Sales. The Closing Stock number shows up as an asset on the Balance Sheet. This system applies to all three stock valuation methods.

Now, we demonstrate how you calculate the Cost of Goods Sold using the FIFO method. With this method, you assume that the first items you receive are the first ones you sell, and because the first items you receive here are those in Opening Stock, we start with them:

Date

Quantity (Unit Price)

Total

Opening Stock

50 (£10)

£500

1 April

150 (£10)

£1,500

15 April

150 (£25)

£3,750

30 April

125 (£30)

£3,750

Cost of Goods Sold

475

£9,500

Closing Stock

75 @ £30

£2,250

Note: Only 125 of the 200 units purchased on 30 April are used in the FIFO method. Because this method assumes that the first items into stock are the first items you sell (or take out of stock), the first items you use are those on 1 April. Then you use the 15 April items, and finally you take the remaining needed items from those bought on April 30. Because you bought 200 on April 30 and you only needed 125, 75 of the items you bought on April 30 are left in Closing Stock. The Cost of Goods Sold figure, which is £9,500, is the sum of the total values of the units that are deemed to have been sold to arrive at this figure (£500 + £1,500 + £3,750 + £3,750).

Next, calculate the Cost of Goods Sold using the LIFO method. With this method, you assume that the last items you receive are the first ones you sell, and because the last items you receive were those you purchased on April 30, we start with them:

Date

Quantity (Unit Price)

Total

30 April

200 (£30)

£6,000

15 April

150 (£25)

£3,750

1 April

125 (£10)

£1,250

Cost of Goods Sold

475

£11,000

Closing Stock

75 @ £10

£750

Note: Because LIFO assumes the last items to arrive are sold first, the Closing Stock includes the 25 remaining units (150 purchased less 125 used/sold) from the 1 April purchase plus the 50 units in Opening Stock.

Here’s how the use of stock under the LIFO method impacts the business profits. We assume that you sell the items to the customers for £40 per unit, which means total sales of £19,000 for the month (£40 × 475 units sold). In this example, we just look at the Gross Profit, which is the profit from Sales before considering expenses incurred for operating the business. We talk more about the different profit types and what they mean in Book IV Chapter 1. The following equation calculates Gross Profit:

·        Sales – Cost of Goods Sold = Gross Profit

Table 3-1 shows a comparison of Gross Profit for the three methods used in this example.

Table 3-1 Comparison of Gross Profit Based on Stock Valuation Method

Profit and Loss Statement Line Item

FIFO

LIFO

Averaging

Sales

£19,000

£19,000

£19,000

Cost of Goods Sold

£9,500

£11,000

£10,146

Gross Profit

£9,500

£8,000

£8,854

Looking at the comparisons of Gross Profit, you can see that stock valuation can have a major impact on your bottom line. LIFO is likely to give you the lowest profit because the last stock items bought are usually the most expensive. FIFO is likely to give you the highest profit because the first items bought are usually the cheapest. And the profit that the Averaging method produces is likely to fall somewhere in between the two.

Buying and Monitoring Supplies

In addition to stock, all businesses must buy the supplies used to operate the business, such as paper, pens and paper clips. Supplies that businesses haven’t bought in direct relationship to the manufacturing or purchasing of goods or services for sale fall into the category of expenses.

remember Just how closely you want to monitor the supplies you use depends on your business needs. The expense categories you establish may be as broad as Office Supplies and Retail Supplies, or you may want to set up accounts for each type of supply used. Each additional account is just one more thing that needs to be managed and monitored in the accounting system, so you need to determine whether keeping a particularly detailed record of supplies is worth your time.

tip Your best bet is to track supplies that make a big dent in your budget carefully with an individual account. For example, if you anticipate paper usage is going to be high, monitor that usage with a separate account called Paper Expenses.

Many businesses don’t use the bookkeeping system to manage their supplies. Instead, they designate one or two people as office managers or supply managers and keep the number of accounts used for supplies to a minimum. Other businesses decide to monitor supplies by department or division, and set up a Supply account for each one. This system puts the burden of monitoring supplies in the hands of the department or division managers.

Staying on Top of Your Bills

Eventually, you have to pay for both the stock and the supplies you purchase for your business. In most cases, you post the bills to the Trade Creditors account when they arrive, and they’re paid when due. A large chunk of the cash you pay out of your Cash account (see Book I, Chapter 4 and Book II, Chapter 1 for more information on the Cash account and handling cash) is in the form of the cheques you send out to pay bills due in Trade Creditors, so you need to have careful controls over the five key functions of Trade Creditors:

·        Entering bills you need to pay into the accounting system

·        Preparing cheques to pay the bills

·        Signing cheques to pay the bills

·        Sending out payment cheques to suppliers

·        Reconciling the Bank account

remember In your business, the person who enters the bills to be paid into the system is likely to be the same person who also prepares the payment cheques. However, you must ensure that someone else does the other tasks. Never allow the person who prepares the cheques to review the bills to be paid and sign the cheques, unless of course that person’s you, the business owner. (We talk more about cash control and the importance of separating duties in Book II, Chapter 1.)

Properly managing Trade Creditors allows you to avoid late fees or interest and take advantage of discounts offered for paying early, therefore saving your business a lot of money. If you’re using a computerised accounting system, you need to enter the bill due date and any discount information at the time you receive the stock or supplies. (See Figure 3-1 for how you record this information.)

If you’re working with a paper system rather than a computerised accounting system, you need to set up a way to ensure that you don’t miss bill due dates. Many businesses use two accordion files: one set up by the month, and the other set up by the day. On receipt, you put a bill into the first accordion file according to the due month. On the first day of that month, the Purchase Ledger clerk pulls all the bills due that month and puts them in the daily accordion file based on the dates the bills are due. The clerk then posts payment cheques in time to arrive in the suppliers’ offices by the due dates.

In some cases, businesses offer a discount if their customers pay bills early. Sage 50 Accounts allows you to set up for each supplier Settlement Due dates and Settlement Discount percentage figures. For example, if a supplier is set up as ‘10 days’ and ‘2 per cent’, it means that if the bill is paid in 10 days, the purchasing business can take a 2 per cent discount; otherwise, the amount due must be paid in full in 30 days. If the total amount due for a bill is £1,000 and the business pays the bill in 10 days, that business can take a 2 per cent discount, or £20. This discount may not seem like much, but if your business buys £100,000 of stock and supplies in a month and each supplier offers a similar discount, you can save £1,000. Over the course of a year, discounts on purchases can save your business a significant amount of money and improve your profits.

In addition, many businesses state that they charge interest or late fees if a bill isn’t paid in 30 days (although in reality few dare make this charge if they want to retain the business).

Have a Go

Here are some exercises for you to practise the principles discussed in this chapter.

1.     Harry’s Hardware started the month with 25 wrenches on the shelf, with an average per unit value of £3.25. During the month, Harry made these additional purchases:

1 April

100 wrenches @ £3.50

10 April

100 wrenches @ £3.75

20 April

150 wrenches @ £4.00

2.     At the end of the month, Harry had 100 wrenches on the shelf. Calculate the value of the Closing Stock and the Cost of Goods Sold using the LIFO method.

3.     Harry’s Hardware started the month with 25 wrenches on the shelf, with an average per unit value of £3.25. During the month, Harry made these additional purchases:

1 April

100 wrenches @ £3.50

10 April

100 wrenches @ £3.75

20 April

150 wrenches @ £4.00

4.     At the end of the month, Harry had 100 wrenches on the shelf. Calculate the value of the Closing Stock and the Cost of Goods Sold using the LIFO method.

5.     Harry’s Hardware started the month with 25 wrenches on the shelf, with an average per unit value of £3.25. During the month, Harry made these additional purchases:

1 April

100 wrenches @ £3.50

10 April

100 wrenches @ £3.75

20 April

150 wrenches @ £4.00

6.     At the end of the month, Harry had 100 wrenches on the shelf. Calculate the value of the Closing Stock and the Cost of Goods Sold using the LIFO method.

7.     Suppose your company receives an invoice for £500,000 on 31 March that says, ‘Settlement discount of 3 per cent if paid within 10 days of date of invoice.’ How much discount would you receive and by what date should you pay the invoice to receive this discount?

8.     Suppose your company receives an invoice for £100,000 on 31 March that says, ‘Settlement discount of 2 per cent if paid within 15 days of the date of invoice.’ How much discount would you receive and by what date should you pay the invoice to receive this discount?

9.     If you keep track of the amount of stock you have on hand by physically counting how much product is on your shop shelves and in your warehouse on a regular basis, what is this kind of stock system called?

10.  If your stock is counted each time you ring up a sale on your register, what is this kind of stock system called?

11.  If you work in a grocery shop and carefully place the newest loaves of bread at the back of the shelf and bring the older loaves of bread to the front, what type of stock system does your shop probably use?

12.  If you work at a car dealership and you track the sale of a car using the original invoice price, what type of stock system does your dealership probably use?

Answering the Have a Go Questions

1.     Here’s how you’d calculate the Closing Stock and Cost of Goods Sold using the Averaging method:

Opening Stock

25 wrenches @ £3.25

£81.25

1 April

100 wrenches @ £3.50

£350.00

10 April

100 wrenches @ £3.75

£375.00

20 April

150 wrenches @ £4.00

£600.00

Total Goods Available for Sale

375 wrenches

£1,406.25

Average Cost per Unit

£1,406.25/375

£3.75

Closing Stock

100 @ £3.75

£375.00

Cost of Goods Sold

275 @ £3.75

£1,031.25

2.     Here’s how you’d calculate the Closing Stock and Cost of Goods Sold using the FIFO method:

Opening Stock:

25 wrenches @ £3.25

£81.25

Next in:

   

1 April

100 wrenches @ £3.50

£350.00

10 April

100 wrenches @ £3.75

£375.00

20 April

50 wrenches @ £4.00

£200.00

Cost of Goods Sold

 

£1,006.25

Closing Stock

100 wrenches @ £4.00

£400.00

3.     Here’s how you’d calculate the Closing Stock and Cost of Goods Sold using the LIFO method:

First Sold purchased 20 April:

150 @ £4.00

£600.00

Next Sold purchased 10 April:

100 @ £3.75

£375.00

Next Sold purchased 1 April:

25 @ £3.50

£87.50

Cost of Goods Sold

 

£1,062.50

Closing Stock

   

75 from April 1

@ £3.50

£262.50

25 from beginning @ £3.25

£81.25

£343.75

4.     The company receives a 3 per cent discount if it pays the invoice in 10 days – by 10 April. The discount is £15,000 if paid by 10 April. So, you should pay the invoice by 10 April.

5.     The company receives a 2 per cent discount if it pays the invoice in 15 days – by 15 April. The discount is £2,000 if paid by 15 April. So you should pay the invoice by 15 April.

6.     If you physically count your stock on a regular, monthly, quarterly or yearly basis, this is known as a periodic stock count system.

7.     If your business operates a system whereby the till adjusts your stock each time a sale is made, this is a perpetual stock system.

8.     A grocery shop would want the first product in (oldest item) to be the first product out (first sold). So your grocery shop is using the FIFO method.

9.     A car dealership usually wants to maintain a specific identification system because each car in the stock probably has different options and a different cost. So your car dealership is using the Specific Identification method.