We have looked at both revenue and expense
behaviors in isolation. We will expand to a more realistic transaction
flow. Let’s look at an example of a retail business
where the company purchases goods and resell them to customers. We’ll look at how inventory, cost of goods
sold, sales, and cash receipt impact the financial statements. The company has been established with $100k
cash provided by shareholders as initial paid in capital. The company has agreed with the supplier to
supply goods for cash and it is ready to purchase goods for sale. There are four types of inventories. Retail inventories, raw materials, working
progress, and finished goods. When a company purchases goods for resale
without any further machining or processing to add values, the inventory is classified
as retail inventory. Rest of the inventories are booked by the
company that manufactures the finished goods as opposed to purchasing what it sells. Raw materials are the inputs from which products
are manufactured, such as iron ore for steel manufacturing company. Work in process is anything in between raw
material and finished goods. They are partially finished goods that require
further processing. Finished goods are goods that have completed
the manufacturing process but not yet been sold. In this example, we focus on retail inventory. When companies purchase inventory by cash,
cash is reduced and the same amount is booked as inventory. Debit inventory, credit cash. There is no income statement impact. The debit side and the credit side of BS remain
unchanged as only the components of assets changed. When the company sells the inventory, it is
expensed as cost of goods sold. Inventory sold moves to Income Statement and
becomes cost of goods sold. Debit cost of goods sold, credit inventory. Debit corresponds to booking expense, and
credit corresponds to reducing inventory. BS and income statement combined, the debit
side and the credit side are equal. When inventory is sold, revenue is booked
simultaneously. Let’s assume they were sold for $75k cash. $75k cash is booked as revenue is made. Debit cash $75k, credit revenue $75k. Obviously, companies always sell their inventory
above their cost, otherwise it loses money. As a result, its net income is $25k for the
transaction. As we have seen in the past videos, the same
amount of retained earnings increase, linking the income statement and BS. At the end of the transactions, the company
made $25k income, and the balance sheet looks like this.