Inventory and Cost of Sales: Period-End Adjustments

Learning objectives

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

• Explain how inventory affects both profit and the statement of financial position, and why errors in inventory distort gross profit and net assets.
• Calculate cost of sales under a periodic inventory system using opening inventory, purchases (net), and closing inventory.
• Record period-end inventory adjustments using correct debits and credits so that inventory is stated as an asset and cost of sales is stated as an expense.
• Identify and correct common cut-off issues (goods received/invoiced around year-end, goods in transit, returns).
• Apply straightforward inventory write-downs by comparing cost to net realisable value, and explain the impact on profit and net assets.

Overview & key concepts

Inventory is a current asset because it represents goods the business has rights to and expects to sell (or materials expected to be used) in the normal operating cycle. Until those goods are sold, their cost is not an expense. The expense appears when inventory is consumed by sale, through cost of sales.

Because cost of sales is usually one of the largest expenses in trading entities, even small inventory errors can cause large movements in profit. Inventory also affects the statement of financial position: overvalued closing inventory overstates assets and overstates profit; undervaluation does the opposite.

Key ideas used throughout this chapter:

• Periodic inventory system:purchases are recorded during the year; inventory is measured at the period end by count/valuation; cost of sales is calculated from opening inventory, purchases (net), and closing inventory.
• Cost of sales formula (periodic system):
• Cost of sales = Opening inventory + Net purchases − Closing inventory
• Cut-off:transactions must be recorded in the correct accounting period. For inventory, this depends on when the entity has therights to the goods under the delivery terms(legal title can support the conclusion, but it is not the starting point).
• Write-downs:where the amount expected to be recovered from selling an item (after necessary selling costs) is below its recorded cost, inventory is reduced and the reduction is charged to profit.

Core theory and frameworks

1) Inventory and profit: the logic

Inventory links the statement of financial position and profit or loss:

• At the reporting date, unsold goods are anasset(future economic benefit through sale or use).
• When goods are sold, the related cost becomes anexpense(cost of sales).

This produces the matching outcome: revenue from sales is reported in the period of sale, and the cost of the goods sold is reported in the same period.

A helpful way to remember the direction of impact:

• Higher closing inventory (all else equal)→ lower cost of sales → higher profit → higher net assets
• Lower closing inventory (all else equal)→ higher cost of sales → lower profit → lower net assets

2) Cost of sales under a periodic system

Under a periodic system, inventory is not updated for each sale. Instead:

1. Start withopening inventory(last year’s closing inventory).
2. Addnet purchasesfor the year (purchases adjusted for items that affect purchase cost).
3. Deductclosing inventorybased on the year-end count and valuation.

Net purchases typically include:

• Purchaseslesspurchase returns
• Purchaseslesstrade discounts (these reduce the invoice price and are not recorded separately if purchases are recorded net)
• Purchasespluscosts needed to bring goods to a saleable condition (e.g., freight-in/carriage in)
• Purchasesplusaccruals for goods received before year-end but not yet invoiced

Settlement discounts (prompt-payment discounts): these arise from paying suppliers quickly. In practice they may be treated as a reduction of purchase cost or presented separately, depending on accounting policy and system design. Exam questions will normally indicate the intended treatment.

3) Period-end double-entry for inventory adjustments

Many bookkeeping systems use Purchases, Sales and related accounts during the year, then make inventory adjustments at period end. Different ledgers use different naming conventions: some use Cost of sales, others use a Trading account or adjust the Purchases figure before calculating gross profit. The underlying double-entry is the same.

A common year-end approach is:

(a) Transfer opening inventory into cost of sales

• Dr Cost of sales (or Trading account)
• Cr Inventory

(b) Recognise closing inventory as an asset

• Dr Inventory
• Cr Cost of sales (or Trading account)

These entries ensure:

• Inventory appears on the statement of financial position at the reporting date.
• The cost of sales figure reflects the cost of goods sold during the period.

Quick T-account view (to lock in the logic)

Inventory (asset)

• Credit: opening inventory removed at year end
• Debit: closing inventory recognised at year end
• Credit: write-downs (and other reductions)

Cost of sales / Trading account

• Debit: opening inventory brought into the period’s cost
• Debit: net purchases (including accruals for goods received)
• Credit: closing inventory carried forward as an asset

4) Cut-off: the practical test

Inventory and purchases must be recorded in the period in which the business has the rights to the goods under the delivery terms and is exposed to the main benefits and losses from holding them. Physical location is not decisive: goods can be included in inventory even if they are still being transported.

A practical way to think about it is: under the delivery terms, who can direct what happens to the goods and who would bear the loss if they were damaged or lost in transit? Legal title/ownership is often consistent with the answer, but it is supporting evidence rather than the principle.

Common year-end cases:

Goods received before year-end but supplier invoice arrives after year-end

• Include the goods in inventory (if they meet the rights/control test).
• Recognise purchases (or cost of sales) and an accrued liability (often called GRNI).

Supplier invoice received before year-end but goods are received after year-end

• Do not include the goods in inventory at year-end unless the delivery terms indicate rights have already passed.
• If a purchase has been recorded early, it may need reversing until the correct period.

Goods in transit at year-end

• Include in inventory only if rights have passed to the buyer under the delivery terms.
• Ensure the purchase/accrual is recognised once: avoid double counting by both recording the invoice and also raising an additional accrual for the same goods.

5) Write-downs: when cost is too high (lower of cost and NRV)

Inventory is not carried at an amount higher than the business expects to recover from selling or using it. At each reporting date, compare:

• Cost:the cost to buy or produce the item and get it ready for sale, and
• NRV (net realisable value):the best estimate of selling price for the itemless any costs still needed to complete and sell it(for example finishing costs, repackaging, sales commissions, or disposal costs).

If NRV is lower than cost, reduce the inventory figure to NRV. The reduction is an expense in profit or loss (often included within cost of sales). If circumstances improve in a later period and NRV increases, a previous write-down may be reversed, but only up to the item’s original cost.

Typical journal:

• Dr Cost of sales (or Inventory write-down expense)
• Cr Inventory

(If selling costs are mentioned, subtract them to arrive at NRV before comparing to cost.)

Exam-step map (recommended order)

1. Fix cut-off (what belongs in this period?).
2. Build closing inventory at the reporting date (include goods in transit where appropriate).
3. Apply lower of cost and NRV to any affected items (write-downs).
4. Compute cost of sales using the periodic formula.
5. Post the year-end journals (opening/closing inventory plus any accruals and write-downs).

Worked example

Narrative scenario

A retail business, ABC Ltd, uses a periodic inventory system. The year-end is 31 December.

The following information relates to the year:

• Opening inventory: £12,400
• Purchases recorded during the year: £58,300
• Purchase returns: £1,900
• Discounts received on purchases: £700
• Freight-in (carriage in): £1,500
• Closing inventory counted and valued at cost: £15,600
• Goods costing £2,000 were received on 30 December but invoiced on 3 January
• A supplier invoice for £3,000 was received on 5 January for goods delivered on 29 December
• Goods in transit at year-end: £1,200, with rights to the goods confirmed under the delivery terms
• Inventory costing £900 was damaged and could only be sold for £600 (assume no further costs to sell)
• A physical inventory count revealed shrinkage of £500
• Goods sold on 28 December were returned by the customer on 2 January

Required

1. Calculate the cost of sales for the year.
2. Record the necessary journal entries for year-end inventory adjustments (including cut-off and write-downs).
3. Determine the impact of the write-down on profit.
4. Identify the cut-off issues and state the adjustments needed.
5. Explain how closing inventory will appear in the financial statements.

Solution

1) Cost of sales calculation (periodic system)

Step 1: Net purchases

Purchases recorded during the year: £58,300

Adjustments:

• Less: purchase returns: £1,900
• Less: discounts received on purchases: £700
• Add: freight-in: £1,500
• Add: goods received/delivered before year-end but invoiced after year-end:
  • Received 30 December, invoiced 3 January: £2,000
  • Delivered 29 December, invoiced 5 January: £3,000
  • Total accrual for un-invoiced goods: £5,000

Net purchases
= 58,300 − 1,900 − 700 + 1,500 + 5,000
= £62,200

Step 2: Closing inventory at the reporting date

Closing inventory counted at cost: £15,600

Include goods in transit where rights have passed:
15,600 + 1,200 = £16,800 (closing inventory at cost before NRV review)

Apply lower of cost and NRV for damaged goods:

• Cost £900; NRV £600 (assume no selling costs) → write-down £300

Closing inventory after write-down
= 16,800 − 300
= £16,500

Step 3: Cost of sales

Cost of sales
= Opening inventory + Net purchases − Closing inventory (after write-down)
= 12,400 + 62,200 − 16,500
= £58,100

2) Journal entries for year-end adjustments

The entries below assume Purchases is used during the year and inventory is adjusted at year end. (If a Trading account is used instead of a Cost of sales ledger, replace “Cost of sales” with “Trading account”.)

(a) Cut-off: goods received/delivered before year-end but invoiced after year-end

• Dr Purchases (or Cost of sales) £5,000
• Cr Accrued payables / GRNI £5,000

(b) Transfer opening inventory into cost of sales

• Dr Cost of sales £12,400
• Cr Inventory £12,400

(c) Recognise closing inventory at cost (including goods in transit)

• Dr Inventory £16,800
• Cr Cost of sales £16,800

(d) Record the write-down to NRV

• Dr Inventory write-down expense (or Cost of sales) £300
• Cr Inventory £300

(Inventory now carried at £16,500.)

(e) Shrinkage

Under a periodic system, shrinkage is typically captured automatically because the closing inventory figure is based on the physical count. A separate journal is only needed if inventory records must be written down to the counted amount.

3) Impact of the write-down on profit

Write-down = £900 − £600 = £300 (assuming no costs to sell)

This reduces profit by £300 and reduces inventory (assets) by £300.

4) Cut-off issues and adjustments

Goods received 30 December, invoiced 3 January (cost £2,000)

• Include in this period’s purchases/cost of sales.
• Recognise a year-end liability (accrual/GRNI).

Goods delivered 29 December, invoiced 5 January (cost £3,000)

• Same treatment: recognise purchase and a year-end liability.

Goods in transit at year-end (£1,200), rights confirmed under delivery terms

• Include in closing inventory even if not physically on site.
• Ensure the related purchase is not recognised twice (for example, avoid recording both an invoice and an additional accrual for the same goods).

Goods sold 28 December returned 2 January
If returns are expected and can be estimated, revenue and cost of sales are adjusted at the reporting date and two balances are commonly recognised:

• arefund liabilityfor the amount expected to be repaid/credited to customers, and
• anasset for the right to recover the goods(presented within inventory), measured consistently with the cost removed to cost of sales (subject to any write-down if applicable).

If the return is not expected at year-end and only arises after the reporting date, it is usually recorded in the next period (with disclosure considered if material).

5) Closing inventory in the financial statements

Closing inventory is reported as a current asset at £16,500. This includes goods in transit where the business has rights under the delivery terms and reflects the write-down to NRV for damaged items.

In profit or loss, cost of sales is reported at £58,100, incorporating:

• net purchases for the period (including cut-off accruals),
• the closing inventory valuation, and
• the write-down (either within cost of sales or shown separately, depending on presentation).

Common pitfalls and misunderstandings

• Treating purchases as an expense immediately:under a periodic system, purchases form part of goods available for sale; cost of sales is determined after opening/closing inventory adjustments.
• Mixing up trade and settlement discounts:trade discounts reduce the invoice price (record purchases net); settlement discounts depend on policy and question requirements.
• Missing goods received but not invoiced:understates purchases and liabilities and overstates profit.
• Incorrect treatment of goods in transit:the key is rights under delivery terms, not physical location.
• Double counting cut-off items:including goods in closing inventory but also recording both the supplier invoice and a further accrual for the same goods.
• Ignoring write-downs to NRV:overstates assets and profit.
• Overstating closing inventory:reduces cost of sales and inflates profit; the error also carries forward through opening inventory.
• Returns near year-end handled as a pure timing issue:where returns are expected and measurable, revenue/cost of sales and related balances should be adjusted at the reporting date.

Summary

Inventory is a current asset until it is sold. Under a periodic system, cost of sales is calculated using opening inventory, net purchases and closing inventory. Period-end adjustments ensure that:

• closing inventory is stated as an asset at the lower of cost and NRV,
• cost of sales reflects the cost of goods sold in the period, and
• cut-off is correct so purchases and inventory belong in the right accounting period.

Write-downs reduce inventory to NRV and reduce profit in the same period.

FAQ

Why does inventory affect both profit and the statement of financial position?

Closing inventory is an asset at the reporting date, increasing total assets. It also reduces cost of sales for the period, increasing profit. Any error therefore affects both profit and net assets.

What is the key difference between periodic and perpetual inventory systems?

A periodic system calculates cost of sales at period end using opening inventory, purchases and closing inventory. A perpetual system updates inventory and cost of sales continuously as purchases and sales occur.

How do I decide whether goods in transit belong in inventory at year-end?

Include goods in inventory at the reporting date when the business has the rights to the goods under the delivery terms. Physical location does not decide the accounting treatment.

What happens if goods are received before year-end but the invoice arrives after year-end?

The purchase belongs in the current period. Recognise the purchase (or cost of sales) and recognise a liability at year end (often as an accrual/GRNI).

How do write-downs work in simple exam questions?

Compare cost to NRV (selling price less any costs to complete and sell). If NRV is lower, reduce inventory to NRV and charge the reduction to profit or loss.

Glossary

Inventory
Goods held for sale, or materials and items held to be used in producing goods for sale.

Opening inventory
Inventory value brought forward from the previous period’s closing inventory.

Closing inventory
Inventory value at the reporting date, determined by count and valuation, reported as a current asset.

Purchases
Cost of goods acquired for resale (or production), adjusted for returns, discounts and costs needed to bring goods into a saleable condition.

Net purchases
Purchases after deducting purchase returns and relevant purchasing discounts, and adding costs such as freight-in and year-end purchase accruals.

Cost of sales
The expense representing the cost of inventory sold during the period under a periodic system: opening inventory + net purchases − closing inventory.

NRV (net realisable value)
Estimated selling price of an item less any costs still needed to complete and sell it.

Freight-in (carriage in)
Transport and related costs to bring goods to the business; typically included within the cost of purchases.

Cut-off
Ensuring transactions are recorded in the correct accounting period, particularly around the reporting date.

Goods in transit
Goods being transported at the reporting date; included in inventory only if the business has rights to the goods under the delivery terms.

Inventory write-down
A reduction in the carrying amount of inventory when NRV is below cost, charged to profit or loss.

Shrinkage
Inventory losses (for example theft, damage or counting differences) identified through a physical count; under a periodic system it is usually captured through the closing inventory figure.

Periodic system
An inventory system where purchases are recorded during the period and cost of sales is calculated at period end using opening and closing inventory.

Perpetual system
An inventory system where inventory records are updated continuously as purchases and sales occur.