For bookkeeping the primary goal is to organize the information so that a company doesn’t overbuy or make a purchase it will not use or sell. This means there is an authorization hierarchy in processing purchases. To be successful the ledgers must be organized properly, the purchasing process should have orders (purchase orders) and authorization. Finally a confirmation system must exist for receiving. This lesson explains and illustrates this organization and two processes. Your job as the bookkeeper is to understand the purchasing system and to enter data where appropriate. Because of the volume of paperwork involved, purchase orders, receipts and bills; the bookkeeper must attend to this activity daily or fall behind in keeping track of purchases.
The organization of tracking purchases consist of two different systems. The first and of course the one you are most familiar with is the accounting organization. The second is the physical process of ordering, buying and receiving goods. This section of the lesson is restricted to the accounting organization.
If you think about the concept of buying for a business there are basically three different types of purchases.
- Cost of Goods – this is the most common purchase made, for most small businesses the purchase consists of raw materials involved to resell to a customer.
- Expenses – in the bottom half of the income statement are traditional operating expenses. Businesses purchase insurance, office supplies, outside services, utilities and a multitude of other operational needs.
- Fixed Assets – purchase of large ticket items such as transportation equipment or tools.
Notice the first two address regular ongoing operations of the business. The last is a balance sheet issue. Purchases in business refers to the first two and is generally not used as a term related to fixed asset acquisitions. Fixed asset buys are commonly called capital outlays or capital expenditures (CAPEX) and is explained in other lessons.
I encourage bookkeepers and accountants to structure their chart of accounts to reflect the distinctly different types of purchases – cost of sales and expenses. When buying and receiving is complete the original source entry is recorded in a purchases journal. Below is a simple example.
Date ID Bill # Split Description DR CR
Today 4310 COS-Mts 500’ Roll of Wire 79.37
. Tractor 79376 A/P-Suppliers 500’ Roll of Wire 79.37
. $79.37 $79.37
In this entry the 500’ bale of wire went straight to cost of sales and not inventory per the company’s policy. The amount is coded to accounts payable with a bill number attached. Remember a bill means the business owes somebody money for goods purchased or services rendered.
Below is my suggested chart of accounts for this section of liabilities.
A/P – Suppliers
A/P – Subcontractors
A/P – Operations
Remember, accounts payable is a control account. So a vendor ID is assigned to their bill number as illustrated with the purchases journal entry above.
Notice three separate accounts payable accounts? Most businesses only use one, I disagree. With two, one for cost of sales and the other for operations, an owner can easily identify values and importance of disbursements related to business functions. Naturally, greater priority is given to cost of sales payables. In the layout above I included a separate account for subcontractors. Those industries utilizing subcontractors such as construction, technology and service should separate these two primary cost of sales in both the cost of sales section of the income statement and in current liabilities on the balance sheet.
Purchase Order System
To reduce errors and control cash flow businesses should utilize purchase order systems. Those operations with a relatively small staff like five or less should opt out of a purchasing order system. This system may have little to no real benefit for operations this small. Typically the owner is the only person authorizing purchases. But as a business grows and prospers communications become a problem and a lot of times double orders are generated. To eliminate this, small businesses should and larger businesses actually utilize purchase orders.
Purchase orders are documents requesting a supplier deliver certain items at a given price. An identifier is issued with each order usually a number in a sequence. In a good system, the purchase order is created by an employee in need of certain goods or services. Once generated it is forwarded to management, usually the owner, for authorization. The owner may delete certain lines or add additional requests. Once authorized, the purchase order (PO) is forwarded to the vendor for filling. Once delivered, the shipping receipt identifies actual items and count delivered. A warehouse clerk or employee signs a receipt. A copy of the receipt along with the bill is sent to the bookkeeper.
Purchase orders are not customarily a part of the accounting books. However for ease of data flow the purchase order system is typically built into the accounting software. Almost every accounting software and retail inventory software has this process designed into its system.
There is no ledger account for purchase orders. Technically there is no liability yet as the vendor has not filled their respective order. However accounting software will identify the outstanding dollar value of the purchase orders. So it is a good idea when discussing outstanding liabilities or cash flow issues to identify the dollar value of outstanding purchase orders as if they were on the books.
Confirmation of Receipt
In many cases the items purchased are customized or dedicated to a particular project. Worse, they are often delivered to a remote location like a project site or to a customer’s facility. It is important to have an employee verify receipt of items as this is the basis for a liability to the supplier. It is not uncommon to receive a bill in your office and not yet received the respective materials. The best policy for legitimate entry is confirmation of receipt of the respected goods.
Most often vendors cannot fully fill a purchase order. In effect they are partially filled. This creates problems for accounting because the documentation is incomplete. The best procedure is to close all purchase orders that have remained inactive for a set period of time (6-10 weeks). If the vendor desires to fill that order after this period it must be filled off a newly issued purchase order. As with many issues communication with the vendor is important.
As a function of daily operations the bookkeeper matches up the receiving ticket against the bill and the purchase order. If all lines of information match, the bill is legitimate and can be entered into the system. Most accounting software will bring up the PO and automatically enter the bill once all the lines are marked received. The goal is to have the bill’s dollar value match up against the PO value.
Some software programs allow the purchase order to be modified on the fly for number of units or price per unit or even substitutions. This is very advantageous when dealing with purchase orders as it is more common for purchase orders to go unfilled or with incorrect information.
As a bookkeeper advocate expediency and be flexible as this enhances business activity. Remember the goal is to sell product and if there is no product because the supplier shipped a legitimate substitute with a new UPC code and you reject the order; how exactly are you facilitating the real goal of the business? BE FLEXIBLE.
Summary – Tracking Purchases
Purchase orders are used to obtain both goods for resale and other items customarily found in the expenses section of the income statement. A good system uses a sequentially numbered document filled out by an employee in need of a particular item or goods. It is authorized by management and forwarded to the supplier. Once filled and delivered, the goods are confirmed and a receipt is forwarded to the accounting office. The purchase order, receipt and bill from the supplier are matched up for confirmation and the bill is entered into the accounting software. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.