Accounting for inventories
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.
- Explain the use of continuous and period-end inventory records.
Inventories and gross profit
Most businesses hold 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.
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?
The cost per book is $40,000 ÷ 2,000 = $20. The 1,600 books sold cost 1,600 × $20 = $32,000, so the gross profit is $38,400 − $32,000 = $6,400 - not a $1,600 loss. The remaining 400 books, costing 400 × $20 = $8,000, are closing inventory.
It would be inappropriate to compare the full purchase cost of $40,000 with the revenue of $38,400, since this relates to different quantities. Doing so would defy the matching concept, which requires expenses to be matched with the revenues they generate.
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:
Closing inventory = opening inventory + purchases − purchase returns − cost of inventory issued (cost of sales).
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.
Exam focus: Both systems are examinable, and you should be able to explain each one. Continuous weighted average (AVCO) is covered in the next chapter, Inventory valuation. Most exam statement of profit or loss questions, however, give you period-end figures - opening inventory, purchases, and closing inventory - directly.
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 inventory 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.
The period-end system is the one used in the examples that follow.
Inventory adjustment: cost of sales
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.
Carriage inwards (the cost of bringing purchased goods to the business) is part of the cost of purchase under IAS 2, which is why it’s added in the table above. Carriage outwards (delivering goods to customers) is a selling expense, not part of cost of sales. The full IAS 2 rules on cost, net realisable value, and the FIFO/AVCO valuation methods are covered in the next chapter, Inventory valuation.
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
Example: 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. By 31 December 20X3, it had sold all the books for $50,000.
- Cost of goods available for sale: opening inventory $0 + purchases $40,000 = $40,000
- Closing inventory: all 2,000 books were sold, so closing inventory = $0
- Cost of sales: $40,000 − $0 = $40,000
- Gross profit: $50,000 − $40,000 = $10,000
$ $ 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 Answer: gross profit $10,000
Closing inventory at year-end
Example: Closing inventory at year-end
In its second year (starting 1 January 20X4), JB Ltd acquired 5,000 books costing $100,000 for resale. By 31 December 20X4, it had sold 4,500 of the books for $112,500.
- Cost per book: $100,000 ÷ 5,000 = $20
- Closing inventory: 500 unsold books × $20 = $10,000
- Cost of sales: $100,000 − $10,000 = $90,000
- Gross profit: $112,500 − $90,000 = $22,500
$ $ 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 Answer: gross profit $22,500
Recording closing inventory
Once closing inventory is calculated, it has to be brought into the accounting records. Two entries are needed:
- Closing inventory: Dr inventory (statement of financial position, current asset) / Cr cost of sales (statement of profit or loss). This removes the cost of unsold goods from cost of sales and recognises it as an asset.
- Opening inventory brought forward: at the start of the next period, that balance is transferred back out - Dr cost of sales / Cr inventory - since it now represents the opening inventory for the new period.
Using JB Ltd’s 20X4 closing inventory of $10,000, the entry is:
- Dr inventory $10,000
- Cr cost of sales $10,000
This $10,000 appears under current assets in JB Ltd’s statement of financial position at 31 December 20X4. At the start of 20X5, it’s transferred back out of inventory and into cost of sales as the opening inventory for the new period - as shown in the next example.
Opening inventory and closing inventory
Example: Opening and closing inventory
At 1 January 20X5, JB Ltd had 500 books carried forward from 20X4 at a cost of $20 each ($10,000 opening inventory). During 20X5 it purchased another 4,000 books for $80,000 (also $20 each). By 31 December 20X5, it had sold 3,500 books for $87,500.
- Cost of goods available for sale: $10,000 + $80,000 = $90,000
- Books available: 500 + 4,000 = 4,500; books sold: 3,500; closing inventory: 1,000 books
- Cost per book: $90,000 ÷ 4,500 = $20, so closing inventory = 1,000 × $20 = $20,000
- Cost of sales: $90,000 − $20,000 = $70,000
- Gross profit: $87,500 − $70,000 = $17,500
$ $ 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 Answer: gross profit $17,500