As we saw above, cost of sales is presented in the statement of profit or loss but is calculated based on the totals of other ledger balances. Although a computerised accounting system will calculate cost of sales automatically, it is important that you understand the underlying
adjustments that are being processed.
As inventory is a statement of financial position balance, closing inventory at the end of one period becomes opening inventory at the start of the next period. Opening inventory needs to be transferred from the inventory account to the cost of sales account (as it will be sold in the period) using the following journal:
DEBIT Cost of sales £X
CREDIT Current assets – inventory £X
Purchases of inventories are transferred to a cost of sales ledger account via the following double entry:
DEBIT Cost of sales £X
CREDIT Purchases account £X
The opening inventories and the purchases represent the total amount of inventory that a business can sell in a period. The inventory account is only used at the end of a reporting period, when the business counts and values closing inventory, during the inventory count. At the inventory count date, an inventory listing is extracted from the computerised accounting system and a physical count takes place to verify the accuracy and completeness of the listing.
Once an inventory count has been carried out and the business has a value for its closing inventory, the double entry is:
DEBIT Current assets – inventory £X
CREDIT Cost of sales £X
The closing inventory reduces cost of sales (as it represents amounts that have not been sold in the period). The debit balance on the closing inventory account represents a current asset in the statement of financial position.
The balance on the cost of sales ledger account should then be transferred to the profit and loss ledger account as a component of the profit calculation at the end of the period.
DEBIT Profit and loss ledger account £X
CREDIT Cost of sales £X
C H A P T E R 7
Worked example: Accounting for inventories
A business has opening capital of £2,000, represented entirely by inventory. During the first year's trading, when the owner took no drawings, the following transactions occurred.
£
Purchases of goods for resale, on credit 4,300
Payments for trade payables 3,600
Sales, all on credit 8,000
Receipts from trade receivables 3,200
Non-current assets purchased for cash 1,500
Other expenses, all paid in cash 900
All 'other expenses' relate to the current year.
Closing inventory is valued at £1,800.
Requirement
Prepare the ledger accounts, including a cost of sales ledger account and a profit and loss ledger account, for the 12-month reporting period and a statement of financial position as at the end of the reporting period.
Solution
CASH AT BANK ACCOUNT
£ £
Trade receivables 3,200 Trade payables 3,600
Balance c/d 2,800 Non-current assets 1,500
Other expenses 900
6,000 6,000
Balance b/d 2,800
CAPITAL
£ £
Balance c/d 4,600 Inventory 2,000
Profit and loss 2,600
4,600 4,600
Balance b/d 4,600
TRADE PAYABLES
£ £
Cash at bank account 3,600 Purchases 4,300
Balance c/d 700
4,300 4,300
Balance b/d 700
PURCHASES
£ £
Trade payables 4,300 Cost of sales 4,300
NON-CURRENT ASSETS
£ £
Cash at bank account 1,500 Balance c/d 1,500
Balance b/d 1,500
SALES
£ £
Profit and loss 8,000 Trade receivables 8,000
TRADE RECEIVABLES
£ £
Sales 8,000 At bank account 3,200
Balance c/d 4,800
8,000 8,000
Balance b/d 4,800
OTHER EXPENSES
£ £
Cash at bank account 900 Profit and loss 900
INVENTORY
£ £
Capital 2,000 Cost of sales (opening inventory) 2,000
Cost of sales (closing inventory) 1,800 Balance c/d (closing inventory) 1,800
3,800 3,800
Balance b/d 1,800
COST OF SALES
£ £
Inventory (opening inventory) 2,000 Inventory (closing inventory) 1,800
Purchases 4,300 Profit and loss 4,500
6,300 6,300
PROFIT AND LOSS LEDGER ACCOUNT
£ £
Cost of sales 4,500 Sales 8,000
Gross profit c/d 3,500
8,000 8,000
Other expenses 900 Gross profit b/d 3,500
Net profit (transferred to
capital account) 2,600
3,500 3,500
C H A P T E R 7
Statement of financial position as at the end of the period
£ £ ASSETS
Non-current assets 1,500
Current assets
Inventory 1,800
Trade receivables 4,800
6,600
Total assets 8,100
CAPITAL AND LIABILITIES Capital
At start of period 2,000
Profit for period 2,600
At end of period 4,600
Current liabilities
Bank overdraft 2,800
Trade payables 700
3,500
Total capital and liabilities 8,100
The closing debit balance on the inventory account is £1,800, which is shown in the statement of financial position as a current asset.
Interactive question 3: Journals for inventory
In its nominal ledger Wickham plc had a balance on its inventory account at 1 July 20X2 of
£23,490. At the end of the reporting period, 30 June 20X3, it had inventory of £40,285.
Requirement
Prepare the journal entries to record the situation as at the end of the reporting period in the nominal ledger of Wickham plc, in preparation for drawing up the statement of profit or loss and statement of financial position.
See Answer at the end of this chapter.
4 Adjusting the trial balance
Section overview
• The closing inventory is often accounted for after the initial trial balance has been prepared.
• A journal entry is required to adjust the initial trial balance to transfer opening inventories and purchases to cost of sales and record closing inventory.
• A new cost of sales line is added to the trial balance as a result of the journal entries posted.
In the previous section we saw how closing inventory is accounted for in the ledger accounts.
However, in a manual accounting system, the adjustment for closing inventory is often not accounted for until after the initial trial balance has been extracted. Therefore, only opening inventory appears on the initial trial balance. The initial trial balance needs to be adjusted to reflect that the business no longer has opening inventories (these have been sold in the year) and instead has closing inventories (which are carried forward as current assets to be sold in the following year).
The approach is as follows:
Calculate the value of closing inventories (see below).
Prepare the year-end journals for opening inventories, purchases and closing inventories (see above) and enter the journals as adjustment to the initial TB.
Worked example: Adjusting the initial trial balance for inventories Sam's Music Shop initial trial balance as at 31 December 20X5 is as follows:
Ledger balance Initial trial balance
Debit Credit
£ £
Cash at bank 5,123
Opening capital 10,000
Loan 12,000
Non-current assets 20,000
Trade payables 6,800
Expenses 12,785
Purchases 18,425
Sales 38,745
Trade receivables 3,546
Inventories at 1.1.X5 8,754
Drawings 9,158
72,668 72,668
Closing inventories at 31 December 20X5 cost £13,855.
Requirement
Adjust Sam's initial trial balance to reflect closing inventories and calculate his net profit for the year.
Solution
Step 1
Prepare the journal entry to transfer opening inventories to cost of sales:
£ £
DEBIT Cost of sales 8,754
CREDIT Inventories (opening) 8,754
Recording opening inventories as a component of cost of sales Prepare the journal entry to transfer purchases to cost of sales:
£ £
DEBIT Cost of sales 18,425
CREDIT Purchases 18,425
Recording purchases as a component of cost of sales Prepare the journal entry for closing inventory:
£ £
DEBIT Inventories (closing) 13,855
CREDIT Cost of sales 13,855
Recording closing inventories as an asset at the year end
C H A P T E R 7
Step 2
Adjust the initial trial balance to take account of these journals and calculate the final trial balance.
Sam's final trial balance will be as follows:
Ledger balance Initial trial balance Adjustments Final trial balance Debit Credit Debit Credit Debit Credit £ £ £ £ £ £
Cash at bank 5,123 5,123
Opening capital 10,000 10,000
Loan 12,000 12,000
Non-current assets 20,000 20,000
Trade payables 6,800 6,800
Expenses 12,785 12,785
Purchases 18,425 18,425
Sales 38,745 38,745
Trade receivables 3,546 3,546
Inventories 8,754 13,855 8,754 13,855
Drawings 9,158 9,158
Cost of sales
18,425
+8,754 13,855 13,324 72,668 72,668 41,034 41,034 72,668 72,668
Step 3
Prepare the financial statements.
Sam's Music Shop
Statement of profit or loss for the year ended 31 December 20X5
£
Revenue 38,745
Cost of sales* (13,324)
Gross profit 25,421
Expenses (12,785)
Net profit 12,636
* Note that the cost of sales balance comprises the opening inventories + purchases – closing inventories, consistent with the calculation introduced previously.
Sam's Music Shop
Statement of financial position as at 31 December 20X5
ASSETS £ £
Non-current assets 20,000
Current assets
Inventories 13,855
Trade receivables 3,546
17,401
Total assets 37,401
CAPITAL AND LIABILITIES
Opening capital 10,000
Profit for year 12,636
Drawings (9,158)
Closing capital 13,478
Non-current liabilities
Bank loan 12,000
Current liabilities
Trade payables 6,800
Bank overdraft 5,123
11,923
Total capital and liabilities 37,401
5 Counting inventories
Section overview
• The inventory count establishes quantities held in inventory at the end of the reporting period.
Business trading is a continuous activity, but financial statements must be drawn up at a particular date. In preparing a statement of financial position it is necessary to 'freeze' the activity of a business so as to determine its assets, capital and liabilities at that given moment.
This includes establishing the quantities of inventories held.
In very small businesses, when a business holds easily counted and relatively small amounts of inventory, quantities of inventories held at the date of the statement of financial position can be determined by physically counting them in an inventory count.
It is more likely, however, that a business will hold considerable quantities of varied inventory, and will use its computerised accounting system to maintain continuous inventory records. This means that the accounting system keeps a record for each line of inventory item, showing purchases and issues from the stores, and a running total. A few inventory line items are counted each day to make sure the records are correct – this is called a 'continuous' count because it is spread out over the reporting period rather than completed in one count at a designated time.
Once the quantity of inventories is determined then a policy is required for valuing the inventory.
C H A P T E R 7
6 Valuing inventories
Section overview
• Inventory is valued at the lower of (historical) cost of purchase, and net realisable value (NRV).
• NRV is the expected selling price less any costs to be incurred in achieving that sale.
• Cost comprises: purchase price, delivery, import taxes and duties, and conversion costs to bring the item to its present location and condition.