UK Double-entry accounting and a created product

[benkip]

I have a question for an artist (me) whose business involves creating and selling paintings: In double-entry accounting what's the second entry when I add a new painting to my inventory? It seems to me it's actually to credit a capital account belonging to the owner of the business, namely the artist (me) since they are in essence giving their creation (the painting) to the business. So for a £1k painting, you debit the inventory £1k and credit the artist's capital account also by £1k. (Right?)

(let's assume for simplicity that there is minimal materials costs etc—e.g. I could've scribbled a drawing on a paper napkin!)

Many thanks
Benjamin

 

[Werner Reisacher]

Your question has actually more to do with taxation, corporate law, and insurance than accounting.
Unless you sell your art to a third party, the value of the work you have created does not represent a business transaction between two parties. Consequently, all you need to keep track of your finances is a simple cash book. (cash-in/out)
You could set up an independent legal entity that acts as your distributor and sell your creations to that company. From a double-entry accounting point of view, that legal entity would record the transaction:
Debit : Inventory
Credit: Payable (you)
By selling the piece of art, you have transferred to the legal title of that piece to a stand-alone legal entity. Assuming that the art has a real commercial value, you have to make sure that the legal entity obtains insurance coverage since the art is no longer covered by your personal policies.
From a tax point of view, the value you choose is critical since the sale of the art creates a taxable income for you.

 

[benkip]

Thank you Werner. Much appreciated

In short, my proposed solution was correct then. The other entry is to credit a capital account.

(I was contrasting the situation with a company that produces a product from purchased raw materials. In that situation, adding to the inventory in a double-entry system doesn't directly involve an entry in the owner's capital account whereas if the business owner is creating the value—in my case via art—then this *does* directly invoice the owner's capital account. See what I mean?)

 

[Werner Reisacher]

Thank you for your feedback. I understand where you are coming from. The devil is always in the detail.
Yes, you are correct, creating an economic value increases your personal net worth. If you call your net worth "capital" you theoretically credit it to your capital account. However, since we are talking about double-entry accounting, this would defeat the purpose of using double-entry accounting.
There is actually no difference between the creation of the art vs adding value to purchased material in form of art.
The double-entry accounting system was developed to obtain a transparent picture of the annual income and expenses broken down into categories and accounts. This is achieved by separating the accounts (general ledgers) between Balance Sheet (assets/liabilities - or items we own vs. to whom these items belong) and Profit and Loss Statement. (income/expenses)
When we close the books, we list all general ledgers in a Trial Balance. The summary of the debit equals logically the summary of the credits. Otherwise, you are in trouble.
At the end of an accounting period, we separate these general ledger balances between the Balance Sheet and Profit and Loss accounts. Logically, since we have allocated the accounts in the balanced Trial Balance to three categories, Asset - Liability - Profit and Loss the summaries of each category do no longer match. The difference between assets and liabilities equals the summary of the Profit and Loss accounts.
Therefore, by not crediting every single revenue/expense book-entry directly into "capital account", we have a summary of the profit achieved during that period broken down into details on an ongoing basis during the reporting period. When preparing the Financial Statement, we simply add the summary of all these Profit/Loss accounts to the capital account (equity) as a one-time one-sided entry as the "current month/year" profit to the capital. Now, all assets equal all liabilities and the current year's profit shown in the category "capital" of the Balance Sheet equals the summary of the P&L.
At the beginning of the next fiscal year, all Balance Sheet balances, (infinite) are carried forward into the next accounting period. The last year's profit is now included in the capital account as "retained earnings prior periods, and all P&L accounts (periodical) start from zero.

 

[benkip]

Thank you for the useful summary of double-entry. I think I understand the principles and motivation of double-entry. Arguably another main motivation is continual error checking, through ensuring that the accounting equation holds all the time (i.e. sum of all debits = sum of all credits).

Now I'm still not quite sure about the specific example we're dealing with. Presumably there are still two entries when an artwork is added to one's inventory, or the accounting equation won't balance at the end of that day. So what is the second entry? Suppose there were no purchased materials involved. For example, imagine you were Picasso's accountant and Pablo decided to add to his inventory a sketch he'd done on a discarded paper napkin in a restaurant using leftover ketchup. It'd be worth millions. One entry would be to debit his business's asset account called "inventory" and the other entry would be to credit what? My claim is it would be Picasso's capital account. If not that, then what ledger would you credit to balance the accounting equation?

I guess I don't see why crediting his capital account would defeat the purpose of double-entry bookkeeping because it would maintain the accounting equation and in doing so help confirm a lack of error (which, as I say, is one of the main motivations for double-entry).

 

[benkip]

UPDATE: I now see what you were saying Werner. My mistake was in not realising that even artwork with high market value is valued at cost for the purposes of accounting. So Picasso’s sketch would have no impact on the accounts until it sold. Likewise there's no real need for me to keep an inventory of my unsold artwork for accounting purposes (but there is a need for my own records, insurance etc etc).

I'll get there in the end.

 

[Chun]

There is a “stock” account on balance sheet, and “closing stock” and “opening stock” accounts (treated as expenses accounts) on P&L.

If the item remains unsold at the end of the financial year (at the end of each year/period you will need to carry out stock counting processes to determine the value of closing stock):
debit “stock”, credit “closing stock”(@the market value); so the painting is recognised as an asset on the balance sheet, and an expense which reduces the profit of the business as a whole.

If the item was sold during the year (the painting was a new addition, not brought forward from the previous period/year):
Sold in the month 2, debit “cash”, credit “sales”;
Also debit “cost of sale/purchases”, credit the owner’s account or “directors loan account”. At the end of that financial year, do closing stock same as above, that painting will not be included in the stock counting.

The opening stock is always the same as the previous period/year’s closing stock. At the beginning of each period, debit “opening stock “, credit “stock”.

The above processes should be repeated in every period.

 

[benkip]

Thank you Chun.

BUT...

If, for accounting purposes, a painting is valued at cost (rather than sale value), then how would you value it? The artist can't really be expected to work out, for example, "how much cadmium orange did I use on that painting?", especially if it should equate to the recorded cost value of materials when summed over all paintings. That way madness lies.

Presumably the only reason for costing like this anyway is to get a total cost of sales at the end of the period (?). So presumably a better system would be NOT to keep an inventory of work for accounting purposes and just record the cost of materials (and frames etc) in EXPENSES (at a suitable granular level if I want to see how much I spent on different kinds of thing)?

Each painting would then impact on the accounts *only* at the point of sale.

One should of course still keep an archive of work for other purposes (insurance etc.), just not for accounting.

Or am I wrong?

 

[benkip]

I do see what you mean about doing a stock-take at the beginning and end of each period.

 

[Chun]

When you buy frames or cadmium orange etc. can get reimbursed by the business: debit “purchases/cost of materials”, credit “cash”. These are consumable purchases that are recognised immediately no matter how much you use to paint for each piece of work.
You spend time to create the painting so you need to recognise the value of it as “cost of sales”, that is the number of hours used times the hourly rate if you work on the similar project on the market: debit “cost of sale/purchases”, credit the owner’s account or “directors loan account”.
I understand you would like to buy insurance for the paintings. If you don’t want to recognise the painting as an asset of the business, the business cannot make this payment. You need to separate your own money and the business’ money.

 

[Chun]

If you prefer to pay the Insurance yourself, when the item is sold you will need to add the value of insurance you have paid into the “cost of sales”. This is another option that works correctly from the point of accounting purpose.

 

[benkip]

Thank you Chun. Very interesting.

> You need to separate your own money and the business’ money.

I certainly do that and I always have. My insurance policy is paid for from my business account. I think my policy only covers things like artwork in transit to a buyer or a gallery at which point it already has a verifiable sale value. And it’s not done on a painting-by-painting basis.

> You spend time to create the painting so you need to recognise the value of it as “cost of sales”, that is the number of hours used times
> the hourly rate if you work on the similar project on the market: debit “cost of sale/purchases”, credit the owner’s account or “directors
> loan account”.

According to other accountants I have consulted, I can’t do this (as the value of my time is not reliably measurable).

This leaves the cost of sales as being just the cost of the physical items making up the painting, which is basically canvas + paint. If the paint is just a materials expense (which I agree makes it easy) that leaves just the canvas. If this too is just an expense then we’re back at a cost value of the actual painting of zero (with annual cost of sales wrapped up entirely in materials expenses).

Perhaps just the canvas should make up the cost value of a painting in stock? Then

Cost of goods sold = Opening stock + purchases - closing stock

would make some sense with the opening and closing stock being all canvases in possession at the two times (since the difference would be the value of all sold canvases).

 

[Chun]

I still think the value of your time spent on each painting can be measured if you previously were paid by creating some similar pieces, as long as you have the evidences to support. It’s arguable.

 

[Werner Reisacher]

Don't forget HMRC Chun. Unless you want to recognize a taxable profit in the business, you would have to pay the artist. And by doing that, he would generate a taxable income for himself.
Stay safe guys.