Purchase Method in accounting is a process of inventory costing whereby a company purchases goods and services for cash. It is a common accounting method used to account for the purchase of stock on hand, or also known as inventory. A business receives an invoice from its supplier that states what was purchased, how many items were purchased and the price paid. The amount paid on an invoice is then debited to an expense account and the units purchased are credited to a stock asset account in the general ledger. Purchase Method can be used in any business that purchases merchandise for resale, but not for personal use. Once the Purchase Method is chosen it applies until all or part of the business requires another method, which will occur when the business purchases a significant amount of inventory that becomes too expensive to hold or the business becomes seasonal.
How Purchase Method Works
When a company starts the Purchase Method, the accountant records purchases of inventory by debiting a Purchases account and crediting a Cash account. The Purchases account appears in the balance sheet as an asset, while the Cash account is shown in the balance sheet as a liability because cash was paid out. In turn, each purchase gets recorded in a journal as a debit to the Purchases account and a credit to the accounts payable account. When goods are sold, they get recorded in the journal as a debit to an Inventory account and a credit to either Cash or Accounts Receivable depending on whether cash was received or not. If goods were sold for cash then Sales Revenue is debited and Cash is credited. If goods were sold on credit then Sales Revenue is debited and Accounts Receivable is credited. The inventory account has a normal debit balance at the end of each period because purchases are recorded as a debit and goods sold are recorded as a credit. This results in a debit balance in Inventory while Cash or Accounts Receivable have a credit balance.
Why Purchase Method Is Used
The goal of using the Purchase Method of accounting for inventory purchases allows a company to more closely match expenses with revenues on its income statement, which provides better insight into business operations. It also helps simplify inventory accounting because it reduces the number of sub-accounts needed in the general ledger to track stock levels.
Pros & Cons of Purchase Method
The best part about the Purchase Method is that it’s easy to understand and use because inventory purchases are added directly to the balance sheet while sales are recorded in the income statement. This simplifies inventory accounting while providing better insight into business operations. However, there are issues with the Purchase Method too. If a company sells some of its inventory for cash but records the sale as one made on credit, then it will be overstating expenses and understating revenues. This leads to an understatement of assets and liabilities because inventory will appear lower on the balance sheet while accounts payable will appear higher.
Types of Purchase Methods
There are two types of Purchase Methods: the perpetual and periodic methods. Which type a company uses depends on how often inventory quantity counts occur.
It is used when stock levels are counted at the end of every accounting period, such as day, week, or month, to determine whether there’s enough merchandise available for sale. In such cases, the Purchases account is debited and a corresponding credit goes to an Inventory account. This results in both accounts having a normal debit balance at these times.
It is used when stock levels aren’t counted frequently, such as once per year or after significant changes happen that affect inventory quantities and prices, and it’s best to refresh the inventory records. The method suggests to remove items that were on hand at the previous date and add all subsequent purchases. This amounts to a physical inventory count because all amounts are restated, which can lead to higher expenses if lots of products have been bought since the last count.
Advantages & Disadvantages of Each Type
The Perpetual Method is preferred because it’s easier to understand and follow, mainly because the simple Purchase method doesn’t require a lot of explanation. The method has an accurate way to account for inventory purchases and sales which automatically leads to accurate financial statements. However, if a company uses the perpetual method, it must count the quantity of inventory on hand at the end of each accounting period to update its books. The perpetual method also leads to higher expenses if lots of products have been bought since the last count because there are more items on hand for sale.
Periodic Method is best used when a company doesn’t keep track of inventory quantities and prices that often. The method, however, isn’t as accurate as the Purchase method because it is more difficult to track purchases and sales. This means that financial statements could be less reliable. Businesses using a periodic inventory count can avoid expenses related to up-to-date inventory records and still avoid overstating income.
The Purchase Method is a popular accounting technique that’s used to record purchases and sales of inventory. What one should note is that this method gives the least amount of information about business operations, therefore it requires more frequent counting in order to be accurate. However, the amount recorded as an expense may not include all costs associated with purchases. What one should also bear in mind is that the amount recorded as an asset may include items not yet paid for. The purchase method simplifies inventory accounting while giving better insight into business operations. However, this leads to overstatement of expenses and understatement of assets and liabilities because all amounts.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.