- Describe cost of goods sold in relation to the matching principle
Remember, under accrual basis accounting, we recognize revenue as it is earned and expenses as they are incurred in order to match those expenses with the revenue.
It means when we buy inventory, and it is sitting on the lot, lying on the shelf, or hanging on a rack, it is not an expense.
Again, inventory is not recorded as an expense when we buy it from the wholesaler or distributor. It is an asset: something we own that will produce future revenue.
Let’s say Chan Ming owns a sporting goods store. He buys 10 baseball bats from his supplier, AshBats, Inc. at $10 per bat. He just spent $100 on inventory (probably on account, so he now owes AshBats $100). He places three bats on display right inside the front door in a nice rack with some other wooden and aluminum bats, and he puts the other seven in the back storage area.
We won’t write the journal entry for this transaction. Instead, as the sporting good store’s accountants, we’ll just use T accounts to describe the entry:
Next, let’s record the sale of a bat to a customer for $15 using a debit card, described below with T accounts in order to save space. The only balance included is inventory because we don’t have room or time to put all the other data into those accounts.
The sale increased the businesses checking account by $15, so we debited checking and credited Sales Revenue (a).
In addition, one $10 bat left the store in the hands of a happy customer, so inventory decreased by $10 and we recorded a corresponding expense that offsets the $15 revenue (b).
Under the matching principle, we record the expense when we recognize the revenue from the bats. This is one of the most direct examples of the matching principles you will ever use.
If we look at the physical inventory right after that sale, there are 9 bats left that cost $10 each, so the $90 in the accounting records for Inventory is spot on. In addition, we recorded an expense called Cost of Goods Sold that represents the one bat sold, and offsets the $15 in revenue, showing us we made a profit of $5 on that one bat. Of course, that’s not really our profit because we still have to pay rent on the store, insurance, our employees’ wages, and other expenses. But, for this one transaction, before any other deductions, we have a perfectly matched revenue and expense picture.
How would this account have looked if we recorded the $100 purchase of bats as an expense? Fifteen dollars in revenue against $100 expense? That entry wouldn’t have the most useful information because we will have 9 bats to sell. Thus, accrual basis accounting includes inventory and cost of goods sold. That is the major difference between accounting for merchandising (and manufacturing) and service businesses.
Next, we’ll take a closer look at the difference between the sales price and the cost of goods sold., But first, check your understanding of the concept of cost of goods sold.