Definition of Purchases
In the context of companies that sell merchandise, the term purchases refers to the purchases of goods that are intended to be sold to customers.
The cost of the goods that are sold are expensed on the income statement. (The cost of goods sold is likely the largest operating expense and it is being matched to the related sales revenue to arrive at a company's gross profit.)
The cost of the items that are not yet sold are reported on the balance sheet as inventory.
Example of Purchases Reported in the Income Statement
Assume that an online seller begins operations on January 2 by purchasing $5,000 of goods consisting of 1,000 at a cost of $5 each. The goods are going to be sold for $12 each. There are two common ways to account for the inventory and the cost of goods sold:
- Periodic inventory system in which the general ledger income statement account Purchases is used for recording the purchases of goods that will be sold to customers. This account does not get reduced for any goods that are sold. With the periodic system, there is not a general ledger account Cost of Goods Sold.
- Perpetual inventory system in which the purchases of goods are recorded in the general ledger balance sheet asset account Inventory. When goods are sold, the Inventory account is reduced and the amount is recorded in the general ledger income statement account Cost of Goods Sold. The balance in Inventory is perpetually changing because the cost of the purchases and the cost of the sales are recorded in the Inventory account.
If the periodic inventory system is used, the cost of the items in inventory must be calculated by multiplying the units on hand (determined by physically counting the units) times the cost per unit. If there are 80 units in inventory at the end of the accounting period, the cost of the ending inventory and the cost of goods sold (using the periodic inventory system) are as follows:
- Amount from the income statement account Purchases: $5,000 (1,000 X $5)
- Minus: Increase in the balance sheet account Inventory: $400 (80 X $5)
- Cost of goods sold: $4,600 ($5,000 - $400) or (920 X $5)