ACCOUNTING STANDARDS APPLICATION (Instructor Notes-3)

COSTS OF ORDINARY ACTIVITIES

To determine the economic performance of a company, corresponding rules should

apply for the recording of expenses.

The general principle is to record only the expenses incurred for the realization of
revenues of the period, i.e costs are to be associated (or matched) with revenues of the
same fiscal period.

Many expenses are necessary for the realization of ordinary income and are generally
presented as one of the following classifications:

Classification of expenses by nature

Classification of expenses by function.

Classification of expenses by nature

The classification lists expenses by their nature, such as materials consumed, external
charges, taxes and fees, staff costs.

Classification of expenses by function

The classification puts more emphasis on the function of expenses in the activity of
the company.

It distinguishes in particular the cost of sales, administration costs, distribution costs and,
as appropriate, the costs of research and development.

Consumption of Goods

The sale of goods is part of ordinary business operations of the company and requires
previously the purchase of goods.

According to the matching of revenues and expenses, this purchase will be treated as
an expense only at the time of the sale of the goods.
Before the sale, these goods are current assets because economic benefits are
expected, usually on a short term.

APPLICATION - 7

Purchase of Merchandise

On 01/01/2010 the company Alpha buys 100 laptops in order to resell them in the short
term. The purchase price is €500. The initial accounting entry is:

COST of GOODS SOLD

The cost of goods sold is calculated as:

Opening inventory + purchases – closing inventory

APPLICATION - 8

Sale of Merchandise (Permanent Inventory)

In June 2010 Alpha sells 40 laptops for €1,000 (unit price). In September 2010 Alpha
sells another 50 at the same price. The accounting entries are as follows:
The income statement appears as:

∗If there are no additional revenues and expenses, the gross profit corresponds to the
income from operating activities.

 The perpetual inventory is to identify assets and liabilities on a daily basis.

 The periodic inventory is to identify assets and liabilities on a periodic basis.

Many companies do not determine a COGS after each sale, which corresponds to a
perpetual inventory monitoring.

Instead, they often use periodic inventory, which is to determine periodically (quarterly,
annually) their COGS.

The company then determines the total purchases of goods that were available for sale
(initial inventory + purchases for the year) and subtracts the unsold recorded at year end
(ending inventory).

APPLICATION - 9

Sales of Merchandise (Periodic Inventory)

In June 2010 Alpha sells 40 laptops for €1,000 (unit price). In September 2010 Alpha
sells another 50 at the same price. The accounting entries are as follows:
The company establishes the cost of goods sold only at the end of the period:

The company must then enter this information into its books. On the one hand, the
expense must be recognized and, on the other, the inventories must be adjusted.

The income statement appears as:

∗If there are no additional revenues and expenses, the gross profit corresponds to the
income from operating activities.

An inventory change reflects the difference found between amounts of inventory

between two dates.

In several European countries, most companies present the COGS using two
accounts.

They first record the purchase of the exercise as an expense (even if not all consumed)
and then an inventory change (initial inventory – ending inventory) at the closing of
accounts.

This approach uses the same definition of COGS, but expressed differently. Indeed:

COGS = initial inventory + purchases − ending inventory

= purchases + [initial inventory − ending inventory]
= purchases + inventory (inventory change)

From an accounting perspective, companies record purchases as expenses as they

purchase and make the adjustment for inventory change at the year end (for the case of
periodic inventory).
APPLICATION - 10

Perry P Louis, trading as the Umbrella Shop, ends his financial year on 30 September
each year.

On 1 October 2014 he had no goods in inventory. During the year to 30 September

2015, he purchased 30,000 umbrellas costing $60,000 from umbrella wholesalers and
suppliers.

He resold the umbrellas for $5 each, and sales for the year amounted to $100,000
(20,000 umbrellas).

At 30 September there were 10,000 unsold umbrellas left in inventory, valued at $2

each.

What was Perry P Louis's gross profit for the year?

Sales (20,000 units) 100,000

Purchases (30,000 units) 60,000

Less closing inventory (10,000 units @ $2) 20,000

Cost of sales (20,000 units) 40,000

Gross profit 60,000

We shall continue the example of the Umbrella Shop into its next accounting year, 1
October 2015 to 30 September 2016.

During the course of this year, Perry P Louis purchased 40,000 umbrellas at a total cost
of $95,000. During the year he sold 45,000 umbrellas for $230,000.

At 30 September 2016 he had 5,000 umbrellas left in inventory, which had cost $12,000.

What was his gross profit for the year?

Sales (45,000 units) 230,000

Opening inventory (10,000 units) 20,000

Add purchases (40,000 units) 95,000

115,000
Less closing inventory (5,000 units) 12,000

Cost of sales (45,000 units) 103,000

Gross profit 127,000

APPLICATION - 11

On 1 January 2016, the Grand Union Food Stores had goods in inventory valued at
$6,000.
During 2016 its proprietor purchased supplies costing $50,000. Sales for the year to 31
December 2016 amounted to $80,000. The cost of goods in inventory at 31 December
2016 was $12,500.

Calculate the gross profit for the year.

GRAND UNION FOOD STORES

TRADING ACCOUNT FOR THE YEAR ENDED 31.12.2016

Sales 80,000

Opening inventories 6,000

Add purchases 50,000

56,000

Less closing inventories 12,500

Cost of goods sold 43,500

Gross profit 36,500
Consumption of goods: according to the matching of revenues and expenses,
purchases will only be considered as expenses at the time of their sale.

When the sale is realized, assets (stock of goods) are consumed. Since it generates its
Economic benefits, it should be recorded as an expense in the same period as the sale.

Thus, the corresponding cost of the sale (cost of goods sold, COGS) corresponds to the
costs of purchasing goods that were actually sold during the year, and only these costs.

Consumption of Materials

Materials are items intended for consumption in the production cycle.

Goods are purchases that will be resold.

The company usually buys the materials it needs to carry on business several times
during the period.

These must be used quickly, either by being consumed in the production cycle (raw
materials) or sold (goods).

APPLICATION - 12

Purchase of Raw Materials

On 09/28/2009, the company Oward purchases raw materials for €100,000. The
payment period negotiated with the supplier, and which Oward will use completely, is of
30 days. The accounting entries are as follows:
APPLICATION - 13

Recognition of the Consumption of Raw Materials

On the date of the physical inventory, 12/31/2009, Oward has raw materials of €20,000.
This amount must be recognized in the balance sheet and, at the same time, the
expense of €100,000 must be adjusted in order to fit the real consumption of 2009. The
accounting entry that needs to be made is:

The consumption of materials is reflected by a recording of an expense (cost of raw

material used), with an offsetting supplier debt or a cash account under the terms of
settlement.

If the value of the final inventory of material is less than the initial value of the stock, the
company used more than the purchases made during the period and the total value of
the xpense, commonly referred to the cost of raw material used, is greater than the
purchase of materials of the period.

APPLICATION - 14

Consumed Purchases

During 2010, Oward purchases €600,000 of raw materials. The physical inventory at the
end of 2010 shows that the final stock of raw materials has a value of €15,000.

The first accounting entry must recognize the consumption of the old stock of 2009. This
consumption occurs generally during the first days of the new year. There the initial
stock is transferred to the cost of raw material used (an expense in the income
statement):
The finished goods are products manufactured within the company and intended for
sale.

The problem of inventory change is also for finished goods. Unlike materials and
goods, they are not bought from outside, but produced internally from materials
purchased with the assistance of other external services, personnel and various
machinery and other tangible assets.

It is technically impossible to correct at year end all expense accounts relating to the
manufacture of products based on the inventory of finished goods. Nor is this justified in
Economic terms. Raw materials, for example, are consumed during the production
process and no correction of the expense of consumption of material is required.

In contrast, the total consumption recorded during the production cycle does not remain
without a counterpart, as the finished products manufactured are sold or are in storage
awaiting commercialization.
The existence of a final inventory of finished goods thus generates a movement in the
accounts, reflecting the value of the stock in the assets.

As this is an increase in the value of assets created internally, the counterpart of this
inventory change should be a revenue.

The most common name of this account is stored finished goods: it is a revenue
account in the income statement, which offsets the costs of production of goods not yet
sold.
APPLICATION - 15

Finished Goods

During Oward’s physical inventory for 2010, a stock of manufactured goods of €60,000
is recognized. This amount comprises eventually a part of the €605,000 of raw
materials. But it also comprises production costs:

The net effect of the change in the inventory or finished goods on the income of the
Company is determined similarly to the recording of changes in the inventory of
materials and goods.

The initial inventory generates a recording in debit of the Stored finished goods account
and diminishes the income, while the recording of the final inventory will credit that same
account with an opposite effect. The net effect on profit for the period is determined as
the balance between changes in the initial inventory and the final inventory.

Other Goods and Services Purchased and Consumed

Besides the materials and goods, the company has many other consumer goods and
services purchased from third parties. The determination of a reliable income requires
an exhaustive recording of all these services. Here are some examples:

 Subcontracting
 Rentals
 maintenance and repair
 insurance premiums
 study and research
 external staff
 salaries and fees to intermediaries
 advertising, publications, public relations
 transportation
 travel, missions, receptions
 postage and telecommunications
 banking.
APPLICATION - 16

Renting of Commercial Buildings

On 10/25/2010, the accounting department of the company Fast gets an invoice for the
rent of a commercial building for October 2010. The amount of €900 is paid on
10/31/2010. The accounting entries are as follows:

The matching of expenses with revenues prohibits the recording in the current period of
expenses relating to another period. This requires two types of corrections, similar to
what has already been shown for the recording of ordinary income:
An accrued liability is a liability of the company corresponding to the amount of
expense consumed but not yet paid.

The expenses for the period for which invoices have not yet been received should be
accurately estimated and recorded in the period during which they are incurred. The
accounting mechanism must ensure that an expense cannot be recorded a second time
when the invoice is received by the company.

We speak in this case of an accrued liability (or sometimes accrued expenses).

A deferred expense is an asset offsetting an expense recorded but not yet consumed.

The bills that relate to expenses on future periods are recorded, but the impact on the
income of the expense relating to future periods must be transferred to these future
periods. The accounting mechanism must ensure that the expense is removed from the
income of the current period and is recorded in the proper period in the absence of a
new bill.

We speak in this case of a deferred expense.

These two types of correction are part of what are called “adjustments”.
APPLICATION - 17

Phone Costs

On 01/04/2011 Fast’s accounting department gets a phone bill for December 2010.
Usually the December bills are around €400. The exact amount of the bill is €415. The
invoice is paid on 01/07/2011.

Fast cannot action this until January 2011 with the recognition of the phone costs.
Therefore, the accounting department must recognize the most probable amount of
costs for December based on historical data and possible changes of the cost structure.
The related accounting entry is:
Taxes

Taxes are of many forms for a company.

They represent ordinary consumption recorded in the ordinary result and their recording
does not differ from that of other expenses. However, there are often specific accounts
of expenses and a specific line of income taxes in the income statement.

The amount of taxes due and not paid is reported separately in the balance sheet, or in
the notes.

APPLICATION - 18

Property Tax

On 10/30/2010 the Rosello company receives a tax assessment for the 2010 property
tax on its headquarters. The tax amounts to €3,000 and is paid on 11/14/2010. The
accounting entries are:

The taxes, which are based on the profit of the year, can be determined with certainty
only at the end of the year, according to the difference between revenues and expenses
for that year.

They are not part of the taxes in line with those addressed here and are on a special line
in the income statement just before the net profit of the company.