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Ascertainment of Cost of Goods Sold. Trading account : Direct

Incomes/Expenses
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9

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.

final,accounts,financial,accounting,trading,profit,loss,account,balance,sheet,trial,balance,work,sheet,adjustmen
ts

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.

Am
Particulars ou Amount
nt

Opening Stock 20,000

(+) a) Purchases (Cost Value) 2
b) Direct Expenses , 3,02,000
Total Value of Goods 4 3,22,000
(−) a) Closing Stock (Value) 8
b) Stock Unused for Trading , 50,000
Cost of Goods Sold 0 2,72,000
0
0

5
4
,
 0
0
0

3
6
,
0
0
0

1
4
,
0
0
0

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 Sales − (Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Unused for
=
Profit 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.

Dr Trading a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Opening Stock – By Sales –

To Purchases – By Stock Unused –
To Direct Expenses – 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.

final,accounts,financial,accounting,trading,profit,loss,account,balance,sheet,trial,balance,work,sheet,adjustmen
ts

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

Dr Trading a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Opening Stock 20,000 By Closing Stock 36,000

To Purchases 2,48,000 By Stock Unused 14,000
To Direct Expenses 54,000

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.

Dr Trading a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Opening Stock 20,000 By Closing Stock 36,000

To Purchases 2,48,000 By Goods Unused 14,000
To Direct Expenses 54,000 By Cost of Goods Sold 2,72,000
c/d

3,22,000 3,22,000

To Cost of Goods Sold 2,72,000 By Sales 3,80,000

b/d 1,08,000
To Gross Profit

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
Dr Trading a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Opening Stock 20,000 By Sales 3,80,000

To Purchases 2,48,000 By Goods Unused 14,000
To Direct Expenses 54,000 By Closing Stock 36,000
 To Gross Profit 1,08,000

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.

Dr Goods Consumed a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Opening Stock 20,000 By Goods Unused 14,000

To Purchases 2,48,000 By Closing Stock 36,000
To Direct Expenses 54,000 By Trading a/c 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.

Dr Trading a/c Cr

Amount Amount
Particulars Particulars
(in Rs) (in Rs)

To Goods Consumed 2,72,000 By Sales 3,80,000

To Gross Profit 1,08,000

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

Dr Trading a/c Cr

Amount Amount Amount Amount

Particulars Particulars
(in Rs) (in Rs) (in Rs) (in Rs)

To Purchases 1,20,000 By Sales –

To Direct Exp. 30,000 By Stock used 25,000
To Gross Profit 5,000 By Closing Stock 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

Dr Trading a/c Cr

Amount Amount Amount Amount

Particulars Particulars
(in Rs) (in Rs) (in Rs) (in Rs)

To Purchases 1,20,000 By Sales –

To Direct Exp. 30,000 By Stock used 20,000
To Gross Profit Nil By Closing Stock 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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