How do I account for stock purchases?

We work with a number of small, but growing, ecommerce retailers and accounting for stock incorrectly is a common issue, and one that prevents them from understanding if their business is performing or not.

To set the scene, we had a new client who runs an ecommerce business on Shopify selling fashion products direct to consumers. When the business made a purchase of stock, at the point they paid for it they would post the payment direct to costs. Sound familiar?

Why is this a problem?

This treatment ignores one of the key accounting principles called matching. 'Matching' requires costs to be reported in the same period as the sales resulting from those costs.

By recognising the costs of stock purchases when they’re bought, and not when they’re consumed in a sale will mean your costs won’t ‘match’ to the period you make your sales.

Not ‘matching’ correctly will impact the profit you report in a financial period.

As an example of not using the matching principle:

• Month 1 you purchase £100 of stock, but make no sales. You record a £100 loss in your accounts, representing the cost of stock recorded as an immediate cost.

• Month 2 you sell all the stock for £200, but make no further stock purchases. You recognise a £200 profit.

• As the matching principle has not been applied the profits of this business are extremely volatile, £100 loss to £200 profit!

As a business owner, without applying the matching principle, you won’t be able to track profit margins effectively from one financial period to another, and therefore it will be difficult to understand whether your business is performing or not.

This will inevitably lead to poor decision making, and could impact the future viability of your business.

The solution is to hold stock as a balance sheet asset until it’s consumed.

By adopting the matching principle, stock purchases are initially recorded on a Stock asset account on the balance sheet. The idea being you’re holding the stock as an asset, that will generate value for your business in the future when it is sold.

When sales of the stock are made, the stock value is reduced based on the number of units sold, and the same amount is taken to your profit and loss account as a cost of sale.

The result is the timing of your stock costs match the timing of your sales, and your profits and margins are accurately reflected month to month.

Back to the example, now using the matching principle:

• Month 1 you purchase £100 of stock, but make no sales. You record a £100 Stock asset in your Balance Sheet. Nil profit or loss is made.

• Month 2 you sell all the stock for £200, but make no further stock purchases. You recognise a £200 of sales. You also reduce your Stock by £100 (as you’ve consumed it all), and record £100 of costs. You recognise £100 of profit, as your costs are matched to the timing of your sales.

• As the matching principle has been applied the true profits and margins are recognised in each period.

In practice…

Our Shopify ecommerce client, mentioned at the start, asked us to review their performance month on month, but as they weren’t accounting for stock correctly their profitability was completely distorted by the timing of their purchases.

Their worst sales month had no stock purchases, so their profits looked great.

Whereas their best sales month, was offset by a huge new stock order for future sales, and didn’t look so good.

We highlighted this issue and systematically reset the way they accounted for stock.

For Shopify businesses we recommend using an integrated app called A2X, which allows you to enter all of your individual stock line unit costs, and automatically calculates the costs of each sale that needs to be transferred from your Stock account.

A2X also fully integrates with Xero, and also ensures all of your Shopify sales, taxes and fees are accounted for correctly in your Xero bookkeeping software, which again means you can understand your numbers properly and see how your business is performing.

We helped our client set up A2X and integrate it with Xero, and they were up and running in no time.

They now have financial performance reports that show true margin and profitability trends month on month, which means they can make decisions about their business with confidence.

If you’re a UK-based, ecommerce business using Shopify and want to know if your business is performing then contact Scotch Accounting.

Learn more about how Scotch Accounting can help you manage your business finances and book a free discovery call here.

Simple, clear and proactive services focused on driving your business forward.