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Companies incur various expenses that are crucial for their operations. One of these includes purchases, which are direct costs. Usually, they involve expenses incurred on purchasing raw materials or products. Companies report these costs in the income statement as a part of the cost of goods sold. However, most companies usually include them as net purchases.
What are Net Purchases?
When companies purchase products for resale or manufacturing, their expenses rise. These expenses also increase the purchase costs reported on the income statement. However, several items exist, which can result in a decrease in this amount. Accounting standards require companies to disclose these items in the income statement. These disclosures fall under net purchases as deductions from gross purchases.
Net purchase is the gross amount of purchase made by a company minus deductions for specific items. For most companies, these deductions include purchase discounts, returns, and allowances. In accounting, a purchase is an expense account, while these accounts form contra expense accounts.
What are the components of Net Purchases?
Net purchases have several components which affect the final figure reported on the income statement. The most significant of these is a company’s purchases. As mentioned, it usually includes costs incurred on manufacturing materials or resalable products. Without any deductions, it is known as gross purchases. When converting this figure into net purchases, the following three components are crucial.
Purchase returns
Purchase returns include any items that companies return to the supplier. Companies may return goods to suppliers for various reasons, for example, when they receive damaged items. Since companies have already recorded the purchase expense in the accounts, they cannot reverse it. Instead, they use the purchase returns account to reduce the figure through a contra account.
Purchase Discounts
When companies purchase goods on credit, they may receive a cash discount. This discount involves paying the value of those goods within a specific time period. For example, a supplier may offer its customer a 10% discount if they pay within 15 days with a credit term of 30 days. For the purchaser, this discount reduces the cost of the goods purchased. Therefore, they result in a deduction from the gross purchases.
Purchase Allowances
Purchase allowances have similar features as purchase discounts. However, it does not entail a prompt or early payment. Instead, it involves the reduction in prices of goods for various reasons. For example, a supplier may offer a company a reduction in price for damaged goods. Purchase allowances are a decrease in the price of goods purchased to avoid purchase returns.
What is the formula for Net Purchases?
The formula for net purchases is straightforward after considering its components. As mentioned, it is the residual amount after deducting returns, discounts, and allowances from gross purchases. Therefore, the net purchases formula is as below.
Net Purchases = Gross Purchases – Purchase Returns – Purchase Discounts – Purchase Allowances
Usually, companies report this figure in the notes to the financial statements. The net purchases amount goes into the income statement.
Example
A company, Blue Co., made total purchases of $100,000 during an accounting period. Of these purchases, the company returns $10,000 worth of goods to suppliers. Blue Co. also received discounts of $6,000 during the year for early payments. Lastly, the company accepted allowances of $4,000 for purchases that included faulty products. Therefore, the company’s net purchases will be as follows.
Net Purchases = Gross Purchases – Purchase Returns – Purchase Discounts – Purchase Allowances
Net Purchases = $100,000 – $10,000 – $6,000 – $4,000
Net Purchases = $80,000
Conclusion
Net purchases include a company’s gross purchases minus returns, discounts, and allowances. Similarly, three components are crucial to this amount. These include purchase returns, discounts, and allowances. Companies report net purchases in the income statement. However, these deductions appear on the notes to the financial statements.
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