Purchases are goods bought for resale, and they become an expense only when the goods are sold. Goods that are still unsold at the year end sit in the statement of financial position as inventory.
This lesson builds on cost of sales from a stock movement. It also connects to the difference between cash paid and expense recognised that you met in accruals and prepayments.
When does a cost become an expense?
An expense belongs to the period in which the business gets the benefit. For goods bought to resell, the benefit arrives when they are sold. Until then the business simply holds them, and holding goods is not a loss.
Not all spending is purchases, either. Three types of spending need to be separated:
- Goods for resale are purchases and flow into cost of sales.
- Items used for running the business over several years (shelves, vehicles) are non-current assets.
- Items used up in the period (cleaning supplies, stationery) are expenses.
How to separate them, step by step
- Ask what the item is for. Resale, long-term use or use within the period.
- For goods for resale, record the whole amount as purchases.
- At the year end, count what is unsold and carry that cost forward as closing inventory.
- Charge to profit only the cost of goods sold: opening inventory + purchases − closing inventory.
Worked example
Gerai Mawar starts the year with no inventory. It buys 500 units at RM 12 each, RM 6,000 in total, and pays by bank transfer. During the year it sells 380 units at RM 20 each.
Cost of goods sold: 380 × 12 = RM 4,560.
Closing inventory: 120 units × 12 = RM 1,440.
Check: 4,560 + 1,440 = 6,000, which equals the purchases.
Sales: 380 × 20 = RM 7,600.
Gross profit: 7,600 − 4,560 = RM 3,040.
The business paid out RM 6,000 in cash, but the expense in the income statement is RM 4,560. The other RM 1,440 is still an asset on the shelf. It will become an expense in the year those 120 units are sold.
The mistake to watch for
A common slip is to charge all the purchases as an expense.
Mistaken working: profit = 7,600 − 6,000 = RM 1,600
The student matched the cash paid against the sales and ignored the goods still on the shelf.
The error is RM 1,440, which is exactly the cost of the unsold units. Profit is understated, and the statement of financial position would leave out an asset worth RM 1,440. The fix is to ask, “How many of the goods bought have actually been sold?” before putting any figure into the income statement.
Check yourself
1. Classify each as purchases, a non-current asset or an expense: (a) 200 shirts bought by a clothing shop to resell, (b) a display counter for the same shop, (c) cleaning cloths used in the shop.
Show answer
(a) Purchases, because the shirts are for resale. (b) Non-current asset, because the counter is used for several years. (c) Expense, because the cloths are used up within the period.
2. A shop buys 300 units at RM 8 each and sells 250 of them. Find the cost of sales and the closing inventory.
Show answer
Cost of sales: 250 × 8 = RM 2,000. Closing inventory: 50 × 8 = RM 400. Check: 2,000 + 400 = 2,400 = 300 × 8.
3. A business has no opening inventory, purchases of RM 7,500, closing inventory of RM 1,800 and sales of RM 9,000. Find gross profit, and the gross profit if the whole purchases were wrongly charged.
Show answer
Cost of sales: 7,500 − 1,800 = RM 5,700. Gross profit: 9,000 − 5,700 = RM 3,300. Wrongly charging 7,500 gives 9,000 − 7,500 = RM 1,500, which is RM 1,800 too low.
Where this leads next
The next question is how to value the unsold goods when some may sell for less than they cost. See applying a stated valuation principle. The cash versus profit bridge shows cash paid and profit side by side for a simple trading year.
If the difference between cash and profit still feels slippery, online one-to-one Accounting tuition gives you a teacher who can use your own questions to make it concrete.