Making revenue and recognizing it is one thing, but against all revenue earned you most certainly incur some expenses. It’s the same with everything in the world. To earn something, you first need to give up a thing or two. So as a consequence you have just after revenue on the income statement a line labeled as ‘cost of sales’ or ‘cost of goods sold’. The naming really depends on the type of business and means used to earn revenue. Either its goods you are selling in which case the name is obviously ‘cost of goods sold’, or if its services, than you should replace the word ‘goods’ with ‘services’ and so on. But understandably not all expenses are put under ‘cost of sales’ although it may feel like appropriate. There are different types of expenses one incurs over course of business, but not all are ‘cost of sales’ obviously.
Expenses directly attributable to sales
According to IFRS and most accounting standards expenses recognized as ‘cost of sales’ on the income statement are the ones that are directly attributable to sales. Generally speaking they are expenses a company has incurred to make a sale happen. And only those expenses, nothing else. When most classifications are easy to apply and understand, some create confusion and some are even forgotten.
As a simple rule, ask yourself ‘Had this expense incurred if I hadn’t done the sale?’ If the answer is ‘no’, it’s attributable to sales and should be recognized under ‘cost of sales’. It’s an easy method of splitting expenses between groups on the IFRS income statement.
Expenses usually put under ‘cost of sales’ are of course the ones incurred to purchase goods to be sold, inventory and goods used in the production of finished products, but also transport charges to deliver goods to customer for an example. Depending on the type of business, some payroll expenses may also fall under ‘cost of sales’.
Accounting for discounts and ‘cost of sales’
What however sometimes is recognized as ‘cost of sales’, but shouldn’t be so, is any discount given. Discount is always reducing revenue on the income statement. Yes, this expense hadn’t occurred if you hadn’t done the sale, but as a general rule under revenue you should recognize the fair amount of earnings received. Simply put, although the sales price for a new digital camera was originally 100 EUR, you gave a discount of 20 EUR, so this means that you actually received 80 EUR. On the income statement your ‘net sales’ totals 80 EUR (100 EUR revenue minus 20 EUR discount) and the ‘cost of sales’ is the cost price of this camera, which for this example is let’s say 50 EUR.
The accounting entries are as follows:
Debit:
‘cost of sales’ 50
‘discounts given’ 20
‘accounts receivable’ 80
Credit:
‘revenue’ 100
‘inventory’ 50
As you can see, you have charged the camera to expenses, decreased as a result your inventory, but also recognized a receivable balance and revenue on the income statement. Note that the line ‘discounts given’ or something similar is always under ‘net sales’ on the income statement.
In summary, under ‘cost of sales’ you always recognize expenses that are directly attributable to sales. They need to relate to sales and reflect all the charges a company has made to make a sale happen.