Accounting for purchases is a must-know if you are starting or working in a business involved in manufacturing or trading.
In this post, I will guide you on what purchases signify in accounting, how to go about purchases accounting entry, we’ll also look into the special case of asset purchases accounting and the types of purchases that exist.
In the case of a manufacturing outfit, purchases involve the buying of inventory of raw materials which would be processed into finished goods before being sold in the ordinary course of business to generate revenue. For a trading company, it simply means the buying of finished goods for resale for the business to turn over revenue in any accounting period.
Purchases are above the line expenses in the income statement. If a business makes any purchases of inventory during a period, they’d be recognized in the calculation of the cost of sales which is removed from Revenue to get Gross Profit. i.e.
Cost of Sales = Opening inventory at the beginning of the accounting period + Purchases – Closing Inventory at the end of the year.
Treatment of Asset Purchases in Accounting
This is a special case of purchase because you may already know by now that while all purchases are expenses, not all purchases are items of the Income Statement.
It is important to know that purchases of assets like land, buildings, furniture do not reflect in the income statement. They are capitalized and recognized in the balance sheet (statement of financial position) where they’ll be depreciated over their estimated useful life.
Tip: if an entity’s ordinary business operation is the trade of motorcycles, motorcycles would be his inventory and hence the value of the motorcycle he has at the end of each accounting period would make his cost of sales i.e. they will be items of the Income Statement.
However, if the entity manufactures bread or does other business asides from selling motorcycles, motorcycle purchases won’t be itemized in the Income Statement, they will be recognized on the Statement of Financial Position as an asset for the business.
Types of purchases in accounting
Purchases could be on either credit or cash basis, let’s analyze each of these purchases detailedly.
This is where a business buys inventory of goods and pays cash immediately either via physical cash, bank transfer, POS machine or whatever means available.
Whenever there are cash purchases, the double-entry principle says that:
- Purchase ledger a/c is debited with the value of cash paid and
- Cash or Bank ledger a/c is credited with the value of cash paid.
Buying inventory of goods on credit means payment of money is deferred until a later period. Usually, businesses prefer to buy on credit as it means they have less money tied up in inventory and can therefore do other things with the available cash. In business, cash is king, right?
Here, the double-entry principle for credit purchases are:
- Debit the purchases a/c with the value of credit purchase.
- Credit the Account Payable a/c with the same value.
In this case, the Account Payable a/c is a liability for your business and anytime you pay for such credit purchase, you will:
- Debit the account payable a/c.
- Credit the cash a/c.
You will need to keep healthy payable days. Otherwise, your creditors may deprive you of the opportunity of buying on credit from them in extreme cases.
Payable days is the number of days it takes your business to pay your creditors (Suppliers). Paying your dues within the time agreed with your creditor is how you maintain healthy payable days.