Adjustments for inventory
In the past lessons we saw that the "raw" Trial balance leads to an erroneous Income Statement:
This Income Statement computes a Gross profit (also called "Gross margin") of 600€, because it subtracts all the purchases from the sales.
But the figure of 6400€ is not the value to us of the goods actually sold. The correct figure would be 2800€ (70 items x 40€ per item).
In order to compute the correct cost of goods sold (COGS), we shall first of all make an inventory of the goods unsold and still in the firm at the end of the accounting period (say the 31st of December).
We may already know the amount in inventory thanks to a real time monitoring, like we did in our example:
We read directly from the inventory monitoring sheet (on the right), that our ending stock is 90 items.
Its value, therefore, is 90 items x 40€ per item = 3600€.
Mind you, this is the value to us. It is not its market value, which (if prices are stable) is 9000€.
But anyway, at the end of the accounting year, in most countries a physical inventory is also legally mandatory.
That is why, in France for instance, shops close a day or two at the end of the accounting year to count physically all they have on shelf.
This may also lead to a measurement of theft, by the way. But we shall suppose there was no theft.
Here is a common sign:
The store will be closed this Thursday for inventory
The final inventory, in our example (mini accounting system), is 90 items x 40€ per item = 3600 euros.
We will make a special double-entry in our accounting system into 2 new accounts:
- "Closing stocks IS" account
- "Closing stocks BS" account
The "Closing stocks IS" account is credited 3600€
and the "Closing stocks BS" account is debited the same amount
So it is a correct double-entry as far as the equality of the two figures.
Moreover, because we are in the first accounting cycle, we create an account called "Opening stocks IS", and we debit it 0€.
This could be omitted, but since the TB of the next accounting cycles will have an "Opening stocks IS", for consistency we add it here too.
So our partially adjusted TB now looks like this
You'll not be surprised that
- Opening stocks IS and Closing stocks IS will be "Revenue accounts" (going into the Income Statement)
- while Closing stocks BS will belong the "Capital accounts" (going into the Balance Sheet).
And finally, our Income Statement now looks like this
The top part of this IS is called the "Trading account". It is now final and correct.
The purchases of 6400€ (in debit) are "corrected" by the closing stocks IS of 3600€ (in credit).
So the new Gross margin (= gross profit) is 7000 - (6400 - 3600) = 4200.
Formula for the Cost of Goods Sold (COGS):
The general formula for the COGS in a shop is
COGS = Purchases - Variation of stocks
Here it yields
COGS = 6400 - [ 3600 - 0 ] = 2800€
And the Trading account is made of the Sales minus the COGS, which yields the Gross proft (also called Gross margin).
In the next lessons, we shall see the other adjustments which have to be made to the Trial balance to reach a totally correct Income statement..