How to record a sale: revenue, cost of sales and inventory

How to record a sale: revenue, cost of sales and inventory

When your business sells merchandise, cash comes in and a product leaves the shelf. For the owner, that moment can be summed up in a single idea: we made a sale. For accounting, however, two different economic events take place, and each one needs its own record. The first is the revenue: the business has earned the right to receive the value of the sale. The second is the inventory leaving: the merchandise that was delivered is no longer available, so it must be removed from the assets while the cost of that merchandise is recognized as an expense.

In this lesson of the accounting manual you will see, with a complete numerical example, why a sale is recorded twice: once for the revenue and once for the cost of sales against inventory. We will look at the two entries in a table, the effect of each one on the accounts, the difference between selling for cash or on credit, how the perpetual and periodic systems handle the goods that leave the business, and the most common mistakes businesses make when recording their sales. In the previous lesson you learned how to work out the cost of sales and how to keep the stock card, also called kardex, product by product. Now we will use that cost to record the whole sale, which is the heart of the accounting cycle of any trading business.

Every sale requires two entries

To understand why two entries are needed, look at what really happens when a customer buys. Suppose someone pays and takes the merchandise. At that instant the business earns revenue, because it has already done its part: it delivered the product. But it also loses an asset, because that product is no longer in the storeroom or on the counter; it is now in the customer's hands. If the business does not record that loss of asset, its books will keep showing, as available stock, merchandise it no longer has.

Accounting works with the double-entry principle: in every operation the total of the debits must equal the total of the credits, and at least two accounts are affected. A sale is no exception; on the contrary, it is one of the best examples. On the revenue side, an asset account is debited, Cash or Accounts receivable, and the Sales account, which collects the revenue, is credited. On the cost side, Cost of sales is debited and Merchandise inventory is credited. They are two entries, each one balanced, and both are made from the same sale, on the same date and with the same supporting document, usually the invoice.

What happens if only the revenue is recorded? The business recognizes the $2,500,000 of the sale, but the inventory still shows the units as if they were in stock. The asset is overstated: the books show merchandise that has already left. Worse still, profit is calculated wrongly, because the cost of what was sold is never recognized as an expense. The result is a business that believes it earned more than it really did and does not know what that sale cost it. That is why the second entry is not an administrative detail: it is half of the accounting truth of the operation.

Behind this requirement there is a simple accounting principle: revenues must be matched with the costs that generated them, in the same period. The profit from a sale is not the price the business received, but the difference between that price and what the merchandise sold cost. If the revenue is recorded today and the cost is never recorded, that profit will never appear correctly calculated in the books. Recording the cost is what allows the income statement to show a real gross profit and the balance sheet to show real inventory.

The complete example: a cash sale of 100 units

To see the two records in action, let us take a concrete case. A business sells 100 units of the same product at $25,000 each. The sale is for cash, which means the customer pays right away. The total value of the sale is $2,500,000. Now comes the figure we already know from the previous lesson: according to the stock card, the unit cost of that product is $15,000. That means the 100 units that left the inventory cost $1,500,000 in total.

With those two figures the gross profit of the operation is calculated: the $2,500,000 of revenue minus the $1,500,000 of cost of sales leaves $1,000,000 of gross profit. In other words, for each unit the business earned $10,000, which is the difference between the selling price of $25,000 and the cost of $15,000. Everything else that appears in the books, the two entries and the effect on the accounts, is simply the orderly way of keeping a record of these three figures: the revenue, the cost and the profit.

The complete record of the sale is made up of two entries. Entry one recognizes the revenue: Cash is debited because the money came in, and Sales is credited because the revenue was earned. Entry two recognizes the merchandise leaving: Cost of sales is debited because that amount is an expense of the business, and Merchandise inventory is credited because the product left the stock. The two entries are summarized in the following table:

Notice that each entry is balanced: in entry one, the debit of $2,500,000 to Cash matches the credit of $2,500,000 to Sales; in entry two, the debit of $1,500,000 to Cost of sales matches the credit of $1,500,000 to Inventory. The value used to take the goods out of inventory is not the selling price but the cost, because inventory is carried at what it cost to buy or produce it, not at what the business expects to receive when it sells it.

What happens in each account

To appreciate the full effect of the sale, it helps to look at the four affected accounts at the same time. The following table summarizes the movement of each one:

At the end of the operation, the accounting equation is still in balance. On the asset side, Cash increased by $2,500,000 and Inventory decreased by $1,500,000, so total assets grew by $1,000,000. On the equity side, the profit from the operation is also $1,000,000: revenue of $2,500,000 minus cost of sales of $1,500,000. Assets and equity grow by the same amount, which is exactly the gross profit of the sale.

Looking at the accounts together shows why the two records need each other. If only entry one were made, profit would appear as $2,500,000 when it is really $1,000,000, and inventory would appear untouched when it really decreased by $1,500,000. Both errors point in the same direction: a business that looks richer than it is. Entry two corrects both things: it takes the expense to where it belongs and leaves inventory with the balance it really has.

Cash sales and credit sales

So far the example assumes a cash sale. But many customers buy on credit: they take the merchandise today and pay in a few days or a few weeks. Does that change the records? Only the first account of entry one changes. In a cash sale, Cash is debited because the money comes in immediately. In a credit sale, Accounts receivable is debited, because what comes in is not money but the right to collect it later. The Sales account is credited in the same way in both cases, and entry two, the one for cost and inventory, is exactly the same.

It is worth remembering it this way: the cost of sales and the inventory leaving do not depend on how the customer pays. The merchandise leaves the storeroom on the day of the sale, whether it is paid for in cash or on credit, and that is why the cost entry is always made at that moment. The form of payment only decides whether the debit of the revenue goes to Cash or to Accounts receivable. We will develop the complete treatment of credit sales, including the collection of receivables and its accounting effects, in the next lesson. For now, it is enough to know that the structure of the records is the same.

Perpetual and periodic inventory systems

The way the inventory leaving is recorded depends on the inventory system the business uses. In the perpetual system, inventory is updated with every movement: when goods are bought, when they are sold and when they are returned. At the moment of the sale, the business knows the cost of what it is delivering and removes it from inventory immediately, exactly as we did in the example. This system requires a reliable unit cost for every withdrawal, and that figure comes from the stock card, which we reviewed in the previous lesson. An auxiliary control such as the stock card, kept up to date with a tool like Kardex Tauro, makes it possible to make the cost entry at the very moment of the sale, without waiting until the end of the month.

In the periodic system, on the other hand, purchases are recorded in separate accounts and inventory is not reduced sale by sale. The cost of sales is calculated at the end of the period, when the physical count of the merchandise is made and compared with the opening inventory and with the purchases of the period. It is a simpler system on paper, but it leaves the business without reliable information during the month. Today, most small businesses can work with the perpetual system thanks to accounting software and a well-kept stock card.

It is worth clearing up a frequent confusion between the stock card and the general ledger. The stock card details the movement of each product: the units that come in, the units that go out and the balance, with their cost. The general ledger, on the other hand, summarizes by account, for example the Merchandise inventory account or the Cost of sales account. The two coexist and complement each other: the stock card provides the cost figure for each withdrawal, with it the cost entry is built, and the result is totaled in the ledger accounts involved. If everything is well kept, the sum of the balances of all the products on the stock cards must match the balance of the Inventory account in the general ledger. That match is a sign that the records are healthy.

Common mistakes when recording a sale

The theory of the two records seems simple, but in practice businesses make mistakes that distort their books. These are the most frequent ones:

• Recording the sale without the cost. This is the most common mistake. Sales is credited and Cash or Accounts receivable is debited, but the entry for cost of sales against inventory is never made. We already know the result: overstated inventory and exaggerated profit. With the figures of the example, the business would show $2,500,000 of gross profit when it really earned $1,000,000, and the inventory would still show the 100 units it already sold. If this mistake is repeated month after month, the books end up very far from the reality of the business.
• Removing the inventory at the selling price instead of the cost. Some owners, seeing that they sold for $2,500,000, credit the inventory for that amount and debit cost of sales for the same amount. That destroys the information: cost of sales would be $2,500,000, gross profit would be zero and inventory would end up with a negative balance of $1,000,000, as if the business owed merchandise that never existed. Inventory is always removed at what it cost, in this example $1,500,000.
• Recording the sale without its supporting document or with the wrong date. Every record must be able to be shown with its invoice, its delivery note or its receipt, and it must stay in the period in which the sale really happened. An end-of-month sale recorded the following month distorts both the month that ended and the month that begins, because the revenue and the cost are separated from the period they belong to.
• Confusing the value of the sale with the money available. If the business sells on credit, the revenue exists from the day of the sale, even though the money has not arrived yet. Not recording the sale until the customer pays leaves the books without the revenue and without the cost in the correct period, and turns accounting into a simple record of cash movements.

Lesson summary

A sale of merchandise produces two records that must be made together. The first one recognizes the revenue: Cash or Accounts receivable is debited and Sales is credited for the value of the sale. The second one recognizes the inventory leaving: Cost of sales is debited and Merchandise inventory is credited for the cost of what was sold, which comes from the stock card. The gross profit of each sale is the difference between those two amounts, and it only appears correctly calculated when both entries are recorded.

The form of payment does not change the cost entry: the merchandise leaves anyway on the day of the sale. The perpetual system removes the inventory at each sale and the periodic system calculates it at the end of the period, but in both cases the stock card and the general ledger coexist: the first one details by product and the second one summarizes by account. Avoid the typical mistakes of recording the sale without the cost or using the selling price to remove the inventory, and your books will show a real profit and real inventory.

The examples in this lesson do not include taxes. Sales can generate taxes that each country regulates differently and that are accounted for in separate accounts, according to local rules, so it is worth reviewing the topic with your trusted adviser. In the next lesson we will look at credit sales: how receivables are recorded, how they are collected and what to do when a customer does not pay. In the meantime, review the records of a recent sale of your business and check that the cost was recorded together with the revenue.