Various Types of Transactions – Part 4e, Collection from Other Source of Revenue and Income (Compensation Received for Loss of Assets)

Business entities may encounter some unfortunate events such as fire, flood or others that cause damage to their assets. After assessment of the damages caused, the insurance companies will then pay the relevant compensation to these business entities. If the assets damaged are fixed assets, the relevant double entries involved in the recording of the loss of the assets have been illustrated in my post: Various Types of Transactions – Pat 4d, Collection from Other Source of Revenue and Income (Proceeds from Disposal of Assets)

However, if the damaged assets are inventories or stocks, the carrying value of the inventories or stock should be deducted against the compensation received to determine the net loss:-

	$
Compensation received	XXXX
Carrying value of inventories	(XXXX)
Loss on damaged inventories	(XXXX)*

*Loss is shown here because the amount of compensation paid by the insurance company would normally not exceed the carrying value of the inventories.

The double entries involved in the recording of the recognition of the loss of damaged inventories are different, depending on the method of recording inventories in the general ledger, i.e. Perpetual Method or Periodic Method. Please refer to my post: Inventories or Stocks – Part 2, Methods of Recording in General Ledger for detailed illustrations of these two methods.

Example

The financial period of ABC Co. Ltd. is from 1 January to 31 December. On 1 January 2006, ABC Co. Ltd paid cash to purchase 1,000 trading goods of $20 each. On 31 July 2006, 800 units were sold at $25 each. On 30 September 2006, 100 units were damaged due to flood. On 15 October 2006, ABC Co. Ltd received a cheque of $1,800 from the insurance company as compensation.

Perpetual Method of recording Inventories

The relevant double entries are:-

1. On 1 January 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Inventories	20,000
   Cash at bank		20,000

2. On 31 July 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cash at bank	20,000
   Sales				20,000

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cost of sales			16,000
   Inventories		*16,000

   *800 units X $20 per unit

3. On 30 September 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Loss on damaged inventories			2,000
   Inventories		2,000

4. On 15 October 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cash at bank	1,800
   Loss on damaged inventories				1,800

The income statement and extract of the balance sheet of ABC Co. Ltd. are shown below:-

Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2006
	$
Sales	20,000	A
Less: Cost of Sales	16,000	B
Gross profit	4,000	C = A - B
Other income	-
Operating expenses: -
Loss on damaged inventories (2,000 - 1,800)	- 200	D
Net profit for the year	3,800	E = C + D
Extract of the Balance Sheet as at 31 December 2006
	$
Current assets
Inventories	2,000
Trade receivables	XXXX
Other receivables, deposits & prepayments:
Rental receivable	XXXX
Rental deposit	XXXX
Utility deposit	XXXX
Cash and bank balances	XXXX
	XXXX

Periodic Method of recording Inventories

The relevant double entries are:-

1. On 1 January 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cost of sales - Purchases			20,000
   Cash at bank		24,000

2. On 31 July 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cash at bank	20,000
   Sales				20,000

3. On 30 September 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Loss on damaged inventories			2,000
   Cost of sales – Transfer to loss on damaged inventories				2,000

4. On 15 October 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Cash at bank	1,800
   Loss on damaged inventories				1,800

5. On 31 December 2006

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Inventories	*2,000
   Cost of sales – Closing inventories				2,000

   *This closing inventories balance is usually determined by way of conducting a stock counting exercise at year end - 100 units X $20 each.

The income statement and extract of the balance sheet of ABC Co. Ltd. are shown below:-

Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2006
	$
Sales	20,000	A
Less: Cost of Sales
Opening inventories	-
Purchases	20,000
Transfer to loss on damaged inventories	- 2,000
Closing inventories	- 2,000
	16,000	B
Gross profit	4,000	C = A - B
Other income	-
Operating expenses
Loss on damaged inventories (2,000 - 1,800)	- 200	D
Net profit for the year	3,800	E = C + D
Extract of the Balance Sheet as at 31 December 2006
	$
Current assets
Inventories	2,000
Trade receivables	XXXX
Other receivables, deposits & prepayments:
Rental receivable	XXXX
Rental deposit	XXXX
Utility deposit	XXXX
Cash and bank balances	XXXX
	XXXX

Inventories or Stocks - Part 2, Methods of Recording in General Ledger

There are two common methods of recording inventories or stocks in the General Ledger of business entities:-

1. The Periodic Method

2. The Perpetual Method

The choice of the method used will directly determine the double entries for the recording of inventories or stocks of the entity concerned.

1. The Periodic Method

Under this method, the inventories or stocks account in the General Ledger would not be updated regularly with the movement of inventories or stocks throughout the whole financial period until the last closing day of the financial period in which the new inventories balance would be determined and adjusted accordingly. The balance of the inventories or stocks account remained at the amount brought forward from the previous financial period i.e. the opening inventories or stocks for the current financial period (this is also the closing balance of inventories or stocks for the previous financial period). At the end of the current financial period, an inventories counting exercise would be conducted to determine the closing balance of inventories and once this is done, the inventories or stocks account in the General Ledger would then be adjusted to reflect the correct inventories or stocks balance on the closing date. On the closing date (i.e. the end of the current financial period), the cost of goods sold would also be determined and deducted against the sales or turnover figure recorded for the current financial period to get the gross profit amount. The steps involved are explained in the following illustration:-

Example 1

Assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

a. Inventories or stocks on hand as at 31 December 2005 comprised the following: -

	Quantity	Unit Cost	Total
		$	$
Stock Type A	100	5	500
Stock Type B	200	7	1,400
Stock Type C	250	20	5,000
			6,900

b. 15 January 2006

Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

c. 20 January 2006

Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

d. 21 March 2006

Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

e. 31 July 2006

Purchase of 50 units of Type A stock at $5 each, on credit. Total purchases were $250.

f. 30 September 2006

Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

g. 30 November 2006

Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The double entries for the above transactions are: -

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Trade debtors	400
Sales				400
(Sales for January 2006)

c. 20 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Purchases			700
Trade creditors		700
(Purchases for January 2006)

d. 21 March 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 March 2006
Trade debtors	3,000
Sales				3,000
(Sales for March 2006)

e. 31 July 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 July 2006
Purchases			250
Trade creditors		250
(Purchases for July 2006)

f. 30 September 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 September 2006
Trade debtors	675
Sales				675
(Sales for September 2006)

g. 30 November 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 November 2006
Trade debtors	3,750
Sales				3,750
(Sales for November 2006)

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: -

Table 1	Stock Type A	Stock Type B	Stock Type C
	Quantity	Quantity	Quantity
Balance as at 1 January 2006	100	200	250
Stock in:
20 January 2006		100
31 March 2006	50
Stock out:
15 January 2006	(50)
21 March 2006		(300)
30 September 2006	(75)
30 November 2006			(150)
Balance as at 31 December 2006	25	-	100

The amount of inventories as at year end i.e. 31 December 2006 was $2,125, comprising 25 units of Type A stock valued at $5 each (Total of Type A stock = $125) plus 100 units of Type C stock valued at $20 each (Total of Type C stock = $2,000).

Note: In this example, the cost of purchases of inventories during the year was intentionally fixed to remain the same as those as at 1 January 2006 for the purpose of simplifying the illustration of this topic. For Type A stock, the purchase of inventories made on 31 March 2006 was at $5 each, the same cost as at 1 January 2006. Similarly, for Type B stock, the purchase cost was $7. In reality, this may not necessary be the case as the price of goods do fluctuate from time to time. In Part 3, the methods commonly used by business entities to determine the unit costs of inventories will be discussed.

Once the closing inventories balance as at 31 December 2006 is determined, the following journal entries would be made to reflect the correct inventories balance: -

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 December 2006
Cost of goods sold			6,900
Inventories		6,900
(Being transfer of opening inventories to cost of goods sold account)
31 December 2006
Inventories	2,125
Cost of goods sold				2,125
(Being recognition of closing inventories)

The relevant accounts in the General Ledger of ABC Co. Ltd are as follows: -

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: -

An important point to note is for the Periodic Method of recording inventories or stocks, the Cost of Goods Sold or Cost of Sales has three components i.e. the opening inventories, the purchases during the year and also the closing inventories. This is also the formula of Cost of Goods Sold or Cost of Sales: -

Cost of Goods Sold/Cost of Sales = Opening Inventories + Purchases – Closing Inventories

Refer to Table 1, you could actually calculate the Cost of Goods Sold or Cost of Sales by multiplying the Quantity of Stock Out with the respective unit cost of the inventories as follows:-

Table 2	Stock Type A			Stock Type B			Stock Type C			Grand Total
	A	B	C = A x B	D	E	F = D x E	G	H	I = G x H	J = C + F + I
	Quantity	Unit Cost	Total	Quantity	Unit Cost	Total	Quantity	Unit Cost	Total
		$	$		$	$		$	$	$
Stock out:
15-Jan-06	-50	5.00	- 250.00	-	-	-	-	-	-	- 250.00
21-Mar-06	-		-	-300	7.00	-2,100.00	-	-	-	- 2,100.00
30-Sep-06	-75	5.00	- 375.00	-	-	-	-	-	-	- 375.00
30-Nov-06	-	-	-	-	-	-	-150	20.00	-3,000.00	- 3,000.00
TOTAL			- 625.00			- 2,100.00			- 3,000.00	- 5,725.00

2. The Perpetual Method

Under the Perpetual Method of recording inventories, the movement of inventories during the financial period is updated regularly to the inventories account in the General Ledger. As a result of this kind of regular updates, more time and effort is required if compared with the Period Method of recording inventories. Refer to the same transactions shown in Example 1, the journal entries required using the Perpetual method of recording inventories are as follows: -

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Trade debtors	400
Sales				400
(Sales for January 2006)
Cost of goods sold			250
Inventories		250
(Being cost of goods sold for January 2006)

c. 20 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Inventories	700
Trade creditors		700
(Purchases for January 2006)

d. 21 March 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 March 2006
Trade debtors	3,000
Sales				3,000
(Sales for March 2006)
Cost of goods sold			2,100
Inventories		2,100
(Being cost of goods sold for March 2006)

e. 31 July 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 July 2006
Inventories	250
Trade creditors		250
(Purchases for July 2006)

f. 30 September 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 September 2006
Trade debtors	675
Sales				675
(Sales for September 2006)
Cost of goods sold			375
Inventories		375
(Being cost of goods sold for September 2006)

g. 30 November 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 November 2006
Trade debtors	3,750
Sales				3,750
(Sales for November 2006)
Cost of goods sold			3,000
Inventories		3,000
(Being cost of goods sold for November 2006)

If you compare the above journal entries with those under the Periodic Method, the difference is for each sale transaction, the cost of goods sold or cost of sales must also be determined and recorded accordingly. This means, a systematic tracking method of the cost of inventories such as shown in Table 2 must be in place to facilitate monitoring the movement of inventories cost. In addition, the journal entries for transferring opening and closing inventories balances to the Cost of Goods Sold account as in the Periodic Method are not required. You would also notice that when ABC Co. Ltd made purchases of inventories, it was the Inventories account that was debited instead of the Purchases account under the Periodic Method. Should there be no incidence of inventories loss due to pilferage etc., the inventories account balance in the General Ledger would reflect the correct balance of closing inventories. The explanation on how stock losses are recorded and reflected will be done in other posts later. The obvious advantage of having a Perpetual Method of recording inventories over the Periodic Method is that those business entities using Perpetual Method are able to know the inventories balance at any point in time.

The relevant accounts in the General Ledger using Perpetual method of recording inventories are as follows: -

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: -

As you can see, there is no purchases account created under the Perpetual Method.