In the examples we studied earlier, the stock purchased was sold at the same price at which it was purchased giving rise to neither a profit or loss. This was done intentionally to avoid complications. In reality this will not happpen since the whole point of running a business is to make profits. A business owner will not go to all the trouble of running a business for no reward in return. Businesses not only need to make profit so that the the business owners could spend the profit, but also to ensure the survival of the business in the long run (by accumulating some of the profits for the rainy days). Businesses will therefore aim to sell goods at a price which is greater than the purchase price, the difference being the profit. This implies that the sales figure includes an element of profit (or loss). If you were to create a stock account with the increases recorded on the debit side and decreases (due to sales) recorded on the credit side, and calculate the difference of the two sides of the account, it would not represent the stock unsold at the end of the period due to the element of profit in the sales figure. A stock account that is being maintained by the business using this basis will not be very helpful since no meaningful analysis or figures can be calculated using this account. In accounting, this issue is therefore dealt by subdividing the stock account into several accounts to record the movement of stock. The transactions related to stock either cause the stock to increase or decrease. Let's deal with each of these in turn. Stock in business increases either due to the purchase of goods or the return to business of the goods that were sold by the business in an earlier period. There could be any number of reasons for this. The goods may have been faulty or different from the ones that were ordered. It is also possible that more goods were sent than were ordered. Two different accounts are opened for the above mentioned purposes:
(i) Purchases Account: In this account purchases of goods are debited
(ii) Returns Inwards Account (also called Sales Return account): In this account goods that have been returned to the business are debited
Stock in business decreases either when Goods are sold or when goods are returned by the business to the supplier, once again for a multitude of reasons.
Again, two different accounts are opened:
(i) Sales Account: In this account sales of goods are credited.
(ii) Returns Outwards Account/Purchase returns account: In this account goods that have been returned by the business to the supplier are credited.
Remember that stock is an asset and these four accounts are bifurcations of this asset, therefore the double entry rules are those used for assets.
Example
On 1 January 2010, goods costing $100 are bought on cash. The dual effect of this transaction is:
1 Increase in the stock asset: The increase in the asset of stock needs a debit entry in an account. The account used for this type of stock movement is the purchases account.
2 Decrease in the asset of cash: Decrease in an asset needs a credit entry. In this case, it would be a credit entry to the cash account.
These two entries appear in the accounts as:
Note that these entries look identical to those you would make if you were using a stock account rather than a purchases account.