Thursday, 17 November 2016

Why the increase in inventory is added to net income for preparing cashflow statement under indirect method

There are a few facts that needs to be considered, before we find the reason for adding the increase in inventory, back to the net income.

1. Whenever a purchase is made, for replenishing the inventory, it can be either done by paying in cash or in credit.

2. Purchase in cash is a real cash outflow.

3. All accounts payables are non cash expenses which reduces the net income EXCEPT PURCHASES.

4. The reason that purchase payables are NOT non cash expenses is because, the other side of the payable entry is a debit to the purchase accounts, not an expense account. Therefore, the payables in purchases do not cause a non cash expense in the income statement.

5. When all the increase in payables are added back to net income, which is the normal procedure for calculating the cash flow statement under indirect method, the purchase payable is also added back along with it. Since purchase payable is NOT a non cash expense, it should not be added back to the net income at all. However it is added back along with all the other payables.

6. So the first mission is to reverse the adjustment of adding back the purchase payables.

7. When calculating net income, a non cash expense called COGS is also subtracted from the gross income. This non cash expense of COGS needs to be adjusted to arrive at the cash flow statement. This is the second mission.

8. Purchases never comes in an income statement. Therefore, the actual cash payed in purchases need to be inserted into the net income to arrive at the cash flow statement which is the third mission.

To summarise,

In order to arrive at the cash flow statement, three missions have to be achieved.

Mission 1. Purchase payables, which are added back with all the other payables, while preparing the cash flow statement needs to be reversed, as it doesn't have a non cash expense counter part in the income statement.

Mission 2. COGS needs to be adjusted, as it is a non cash expense in the income statement needs to be adjusted.

Mission 3. Cash purchases have to be inserted into the net income, as they are not part of the net income calculation.


we know that ΔI=     Purchases-COGS

and               -ΔI=    -Purchases+COGS

Net income  -ΔI=     Net Income-Purchases+COGS

                         =      Net Income-Cash Purchase-Purchase Payable+COGS

                         =      Net Income-Mission 3-Mission 1 + Mission 2

So by reducing the increase in inventory from the net income, we achieve all the necessary missions to arrive at the cash flow statement, by adjusting for cash flow from purchases.

Wednesday, 29 June 2016

COGS, Calculation, Explanation, Formula all in a simple illustration.

The gross profit is simply Sales minus the Cost of the goods sold. It’s quite logical, if you think about it. So you need the Cost of Goods Sold figure (COGS), for a period, to find out the gross profit for that period. How to calculate the COGS if you don't have a computer to do it for you, is what we need to find out.

The first thing to come in mind is to take all the sales receipts and invoices for the period for which you need to find the COGS. Then, find out which all items were sold out. Find the cost of the individual items, from the purchase register. Then calculate the cost of all the items sold. This will be your COGS for that period. By now you can see that it's not that simple at all. But, fortunately, there is another way.

Imagine that you are an accountant recruit at a retail firm. On the first day of your employment, you are asked to calculate the stock (inventory) at the warehouse of the retail firm.  After a day of grueling work, you arrive at an inventory figure, which represents the inventory at the end of the day at the warehouse. Let’s say that it is I1 (Inventory on day 1 at your job). You note it down and soon forget it. 

A few months go by. You are busy at your job. Suddenly your boss asks how much is the COGS for the sales done, from your beginning of your joining date. You scroll through the various registers and find out that there has been lots of purchase of goods, since your date of joining. An the firm has also had a good period, with a lot of sales.  You think of calculating the cost of each items sold, and after sometime, conclude, that it’s quite cumbersome. So you think that you need to find another way.

Then you remember the inventory value I1 (Inventory on day 1 at your job), which you had jotted down on the first day at the firm. 

You know that the inventory values must have been quite changed from the beginning inventory figure I1, due to purchases and sales of goods, that have happened after you started working in the firm.  So you wonder what changes must have happened to I1 , to arrive at the present inventory. You spend almost a day to calculate the present inventory figure, which is  I2 (inventory on the day you are asked to calculate COGS).

You know that purchases increase the  inventory, and sales (measured in COGS) decreases the inventory.  If there were no sales, then I1 + Purchases would have been, the total goods available for sale from day 1 to the present day.  But the sales did happen, and the total goods available for sale must have got reduced by the sale of goods (measured in COGS).  So, the present inventory I2, would be

                    I1 + Purchases-COGS.

This whole story of inventory change can be represented in the equation

                    I2= I1 + Purchases-COGS
OR              COGS= I1- I2+ Purchases

Now you got an easy method to calculate COGS, and you don’t waste any time. So you immediately begin calculating the  the COGS for the period starting from the day of your joining to the day at which you were asked to find COGS.

When the boss asks you the next time, to calculate the COGS for the current financial year, you know that the formula for COGS, you arrived earlier can be used that time too. You can modify your formula and finally arrive at the general formula, which  used world over, for calculating COGS.

                   COGS= I(Beginning)- I(Ending)+ Purchases