Evaluating Carriage Inwards Treatment

Financial Statements of a Sole Proprietorship without Adjustments

Skill: Evaluate

Stimulus

Question

(a) Evaluate which clerk's draft shows the correct gross profit. Justify your answer based on accounting principles.

(b) Explain the effect of the wrong treatment on the business's gross profit and net profit.

(c) Encik Hafiz wants to assess sales performance using the gross profit margin. Recommend a sound decision and justify it.

Thinking steps

1. Identify the nature of the items: carriage inwards and insurance on purchases are costs of acquiring the goods bought for resale.
2. Recall the format rule: costs related to purchases are added to the cost of purchases in the Trading Account, while operating expenses go to the Profit and Loss Account.
3. Compute cost of sales and gross profit for the correct treatment: 15,000 + 70,000 + 3,000 + 2,000 - 12,000 = 78,000; gross profit = 120,000 - 78,000 = 42,000.
4. Compare the two drafts: the wrong treatment raises gross profit by RM5,000, but net profit stays at RM26,000 because the total expenses deducted are the same.
5. Evaluate the impact on decisions: an overstated gross profit and margin can mislead the analysis of sales performance, so choose the principle-based treatment.

Model answer

Aina is correct. Carriage inwards (RM3,000) and insurance on purchases (RM2,000) are costs of acquiring inventory so that it is ready for sale, so they are added to purchases in the Trading Account, not the Profit and Loss Account. The correct gross profit = RM42,000 (Sales RM120,000 - Cost of sales RM78,000, where Cost of sales = 15,000 + 70,000 + 3,000 + 2,000 - 12,000). Bala's treatment overstates gross profit by RM5,000 (RM47,000 versus RM42,000). However, the net profit of both drafts is the same, RM26,000 (42,000 - 16,000 = 26,000; and 47,000 - 21,000 = 26,000), because the total expenses deducted are identical; only the placement of the two items differs. Decision: Encik Hafiz should use the gross profit of RM42,000 and the true gross profit margin of 35% (42,000/120,000) to assess sales performance. Bala's margin of 39.2% (47,000/120,000) is misleading and could lead to wrong pricing or cost-control decisions.