This chapter introduces accounting for inventory, with a focus on how inventory affects cost of sales, valuation, and presentation in the financial statements.

Learning objectives

By the end of this chapter, you should be able to:

• Describe the need for adjustments to inventories in preparing financial statements.
• Record cost of sales and closing inventories.
• Identify which costs should be included in valuing inventories.
• Explain the use of continuous and period-end inventory records.

Inventories and gross profit

Definitions

Inventory

The International Accounting Standard (IAS ) 2 defines inventories as assets:

• held for sale in the ordinary course of business;
• in the process of production for such sale; or
• in the form of materials or supplies to be consumed in the production process or in the rendering of services

Every business has at least one of these categories of inventory. A business incurs costs to buy or produce inventory, and it earns revenue by selling that inventory.

Definitions

Gross profit

It is basically the difference between costs and the revenue earned.

This sounds simple if all inventory is sold by year-end. In practice, some inventory is usually still on hand. That means it would be misleading to calculate profit as “revenue minus purchases,” because the purchases figure includes goods that have not yet generated revenue.

Illustration: Walkthrough

JB Ltd acquired 2,000 books at a total cost of $40,000 for resale. By year-end, only 1,600 books had been sold for $38,400.

Do you know what the profit will be?

So, inventories must be adjusted when preparing the statement of profit or loss. Under the period-end system, we start with purchases and then remove the cost of unsold inventory to arrive at cost of sales. Gross profit is then calculated using:

• Sales revenue
• Less: cost of sales

This becomes clearer once you understand the two inventory systems.

Inventory systems

Generally, there are two main inventory systems available for every business entity. These are:

• Period-end inventory system
• Continuous inventory system

Continuous inventory system

Under this system, a single ledger account is maintained to record all inventory movements. Purchases, issues, and returns of inventory are all recorded in the inventory ledger. At the end of the period, the total value of inventory issued represents the cost of sales. Closing inventory is determined as:

This can also be presented in an account form as depicted below.

The closing inventory balance is usually checked against a physical count at the end of the year.

Because this system records all inventory movements in one place (purchases, returns, issues, and so on), businesses typically do not maintain separate purchases and purchases returns ledger accounts.

This system is straightforward. Since the cost of sales is captured through the inventory ledger as inventory is issued, there is usually no separate year-end inventory adjustment needed to determine cost of sales.

Note: This system is not the basis for the examinations.

Period-end inventory system

Under this system, separate ledger accounts are maintained for inventory movements:

• The purchases ledger records goods acquired during the period.
• The purchase returns ledger records goods returned to suppliers.
• The inventory ledger shows the opening inventory value brought forward from the previous period.

At the end of the year, the closing inventory is determined by valuing the physical stock count. That closing inventory figure is then updated in the inventory ledger.

Profit is calculated as the difference between sales revenue and cost of sales. Importantly, the cost of sales is not the same as total purchases, because not all goods bought during the period are necessarily sold during the same period.

It is clear from our earlier topics that this system is the one being applied.

Inventory adjustment: Cost of sales

Definitions

Cost of sales

Also known as cost of goods sold (COGS), represents the direct costs associated with producing or acquiring the goods or services a business sells. It is determined using:

• Opening inventory - transferred from the inventory ledger account
• Purchases - transferred from the purchases ledger account
• Purchases returns (if applicable) - transferred from the purchase returns ledger
• Closing inventory - transferred from the inventory ledger accounts

The cost of sales is computed as:

	$
Opening inventory	xxx
Add: Purchases (production cost)	xxx
Purchases returns	(xxx)
Add: Carriage inwards (if any)	xxx
Cost of goods available for sale (COGAS)	xxx
Closing inventory	(xxx)
Cost of sales	xxx

As shown above, cost of sales is determined in two steps:

• First, add purchases (or production costs for manufacturers) to opening inventory to get the cost of goods available for sale.
• Then, deduct the closing inventory (goods still unsold at the end of the period) to arrive at cost of sales.

This is why profit cannot be measured as sales minus purchases under the period-end system. Purchases include goods that may still be unsold, so we adjust for inventories.

We will now examine inventory adjustments under three scenarios:

• All inventories sold by year-end (no closing inventory).
• Some inventories unsold at year-end (closing inventory).
• Inventories carried forward from the previous year, with some unsold inventories also at year-end (opening and closing inventories).

No closing inventory at year-end

JB Ltd acquired 2,000 books in its first year of operations (1 January 20X3) costing $40,000 for resale. At the end of the year (31 December 20X3), he sold all the books for $50,000.

• What was JB Ltd’s cost of goods available before sales?

Do you know the answer?

• What was JB Ltd’s cost of goods sold?

Do you know the answer?

• What was JB Ltd’s gross profit for the year?

Do you know the answer?

Below is a presentation as a statement of profit or loss extract.

	$	$
Sales		50,000
Less: Cost of sales
Opening inventory	0
Purchases	40,000
COGAS	40,000
Closing inventory	0
Cost of sales		(40,000)
Gross profit		10,000

Closing inventory at year-end

In the following year (starting 1 January 20X4), JB Ltd acquired 5,000 books costing $100,000 for resale. At the end of the year (31 December 20X4), he sold 4,500 of the books for $112,500.

• What was JB Ltd’s cost of goods available before sales?

Do you know the answer?

• What was JB Ltd’s cost of goods sold?

Do you know the answer?

• What was JB Ltd’s gross profit for the year?

Do you know the answer?

Below is a presentation as a statement of profit or loss extract.

	$	$
Sales		112,500
Less: Cost of sales
Opening inventory	0
Purchases	100,000
COGAS	100,000
Closing inventory	(10,000)
Cost of sales		(90,000)
Gross profit		22,500

Opening inventory and closing inventory

In the following year (1 January 20X5) JB Ltd had 500 books from the previous period. However, in anticipation of sales, they acquired an additional 4,000 books costing $80,000 for resale. At the end of the year (31 December 20X5), he sold 3,500 of the books for $87,500.

• What was JB Ltd’s cost of goods available before sales?

Do you know the answer?

• What was JB Ltd’s cost of goods sold?

Do you know the answer?

• What was JB Ltd’s gross profit for the year?

Below is the presentation in a statement of profit or loss extract.

	$	$
Sales		87,500
Less: Cost of sales
Opening inventory	10,000
Purchases	80,000
COGAS	90,000
Closing inventory	(20,000)
Cost of sales		(70,000)
Gross profit		17,500