A corporation uses the Purchase Method of accounting when it pays cash for its inventory.
It’s a standard practice in accounting for merchandise on hand, commonly called inventory.
Suppliers typically provide businesses invoices detailing the goods purchased together with the quantity and total cost.
The stock asset account receives credit for the purchased units, while the expense account is debited for the amount paid on the invoice.
Any company that buys products in bulk for resale (rather than for internal use) can benefit from using the Purchase Method.
Once the acquisition Method has been selected, it will remain in effect until such time as the business, as a whole or in part, necessitates a different method, such as in the case of the acquisition of a large quantity of inventory that would be too expensive to keep or the transition to a seasonal operation.
What the Buying Process Entails
When using the Purchase Method of accounting, a debit is made to a Purchases account and a credit is made to a Cash account whenever inventory is purchased.
Cash is indicated as a liability on the balance sheet since cash was used to make purchases, but the Purchases account is an asset.
After making a transaction, money is moved from the Purchases account to the Accounts Payable account through a journal entry.
In the journal, a sale results in a debit to Inventory and a credit to Cash or Accounts Receivable, depending on whether or not payment was received in full.
Cash is credited if products were sold for cash and Sales Revenue is subtracted. Credit sales result in a negative Sales Revenue and a positive Accounts Receivable.
Purchases are debited and sales of products are credited, hence the ending balance of the inventory account is always negative.
This causes a credit in Cash or Accounts Receivable and a debit in Inventory.
Purchasing Method: Why It Is Used
A corporation can gain more insight into its operations by employing the Purchase Method of accounting for inventory purchases since it more closely aligns expenses with revenues on the income statement.
It also helps streamline stock-taking by reducing the requirement for specialized inventory accounts within the main ledger.
Comparison of Advantages and Disadvantages of Different Buying Options
Because purchases are simply added to the balance sheet and sales are reported in the income statement, the Purchase Method is straightforward and simple to implement.
As a result, inventory accounting is made easier, and more business information is gained.
However, the Purchase Method is not without its own problems. A corporation will inflate costs and underestimate income if it sells merchandise for cash but treats the transaction as if it were performed on credit.
Inventory will be understated while payables will be overstated, leading to an understatement of assets and liabilities.
Methodologies of Buying
Both one-time and repeating cycles can be used as Purchase Methods. The frequency with which inventory counts are performed will determine the type of system used.
Constant Procedure
Inventory counts are performed at the conclusion of each day, week, or month to ascertain whether or not there is sufficient stock for the upcoming period.
When this occurs, a credit is made to an Inventory account and a debit is made to Purchases. As a result, the balance in both accounts will be negative during these times.
Sequential Procedure
Refreshing inventory data is necessary when stock counts aren’t performed regularly, such as once a year or after significant changes occur that affect inventory amounts and prices.
The procedure recommends replacing what was on hand as of the prior date with any new acquisitions.
All amounts are reset, thus it’s the same as doing a physical inventory count, which can increase costs if a lot of products were purchased after the last count.
The Pros and Cons of Each Variant
Constant Procedure
Given that the Purchase approach doesn’t call for any explanation, the Perpetual approach is favored due to its friendliness to newcomers.
As a result of the method’s careful attention to inventory transactions, the resulting financial statements are always reliable.
But if it employs the perpetual method, it must update its records by counting inventories at the end of each accounting period.
If a lot of products have been purchased since the last count, the perpetual technique causes costs to rise because there are more things available for sale.
Sequential Procedure
The Periodic Method is recommended for businesses that don’t regularly perform stock counts and price checks. Due to the increased difficulty in keeping track of purchases and sales, the method is less reliable than the Purchase method.
This could lead to a loss of confidence in financial reports. Companies that do stocktakes on a regular basis might save money that would otherwise be spent on maintaining accurate inventory records and still avoid overstating profits.
Lessons Learned
The Purchase Method of Accounting is commonly used to keep track of inventory purchases and sales.
Keep in mind, too, that this approach provides the barest minimum of data on how a business is operating, necessitating more frequent counts.
A purchase’s true cost may exceed the amount accounted for as an expense. Keep in mind that the asset quantity may contain things that have not yet been paid for.
In addition to improving visibility into business processes, the buy technique streamlines inventory accounting. However, because of the total, expenses are inflated while assets and liabilities are underestimated.