closing inventories – Accounting Crash Course

Inventories or Stocks – Part 2, Methods of Recording in General Ledger

There are two common methods of recording inventories or stocks in the General Ledger of business entities:-

1. The Periodic Method

2. The Perpetual Method

The choice of the method used will directly determine the double entries for the recording of inventories or stocks of the entity concerned.

1. The Periodic Method

Under this method, the inventories or stocks account in the General Ledger would not be updated regularly with the movement of inventories or stocks throughout the whole financial period until the last closing day of the financial period in which the new inventories balance would be determined and adjusted accordingly. The balance of the inventories or stocks account remained at the amount brought forward from the previous financial period i.e. the opening inventories or stocks for the current financial period (this is also the closing balance of inventories or stocks for the previous financial period). At the end of the current financial period, an inventories counting exercise would be conducted to determine the closing balance of inventories and once this is done, the inventories or stocks account in the General Ledger would then be adjusted to reflect the correct inventories or stocks balance on the closing date. On the closing date (i.e. the end of the current financial period), the cost of goods sold would also be determined and deducted against the sales or turnover figure recorded for the current financial period to get the gross profit amount. The steps involved are explained in the following illustration:-

Example 1

Assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

a. Inventories or stocks on hand as at 31 December 2005 comprised the following: –

	Quantity	Unit Cost	Total
		$	$
Stock Type A	100	5	500
Stock Type B	200	7	1,400
Stock Type C	250	20	5,000
			6,900

b. 15 January 2006

Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.

c. 20 January 2006

Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700

d. 21 March 2006

Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.

e. 31 July 2006

Purchase of 50 units of Type A stock at $5 each, on credit. Total purchases were $250.

f. 30 September 2006

Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.

g. 30 November 2006

Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The double entries for the above transactions are: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Trade debtors	400
Sales				400
(Sales for January 2006)

c. 20 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Purchases			700
Trade creditors		700
(Purchases for January 2006)

d. 21 March 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 March 2006
Trade debtors	3,000
Sales				3,000
(Sales for March 2006)

e. 31 July 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 July 2006
Purchases			250
Trade creditors		250
(Purchases for July 2006)

f. 30 September 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 September 2006
Trade debtors	675
Sales				675
(Sales for September 2006)

g. 30 November 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 November 2006
Trade debtors	3,750
Sales				3,750
(Sales for November 2006)

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1	Stock Type A	Stock Type B	Stock Type C
	Quantity	Quantity	Quantity
Balance as at 1 January 2006	100	200	250
Stock in:
20 January 2006		100
31 March 2006	50
Stock out:
15 January 2006	(50)
21 March 2006		(300)
30 September 2006	(75)
30 November 2006			(150)
Balance as at 31 December 2006	25	–	100

The amount of inventories as at year end i.e. 31 December 2006 was $2,125, comprising 25 units of Type A stock valued at $5 each (Total of Type A stock = $125) plus 100 units of Type C stock valued at $20 each (Total of Type C stock = $2,000).

Note: In this example, the cost of purchases of inventories during the year was intentionally fixed to remain the same as those as at 1 January 2006 for the purpose of simplifying the illustration of this topic. For Type A stock, the purchase of inventories made on 31 March 2006 was at $5 each, the same cost as at 1 January 2006. Similarly, for Type B stock, the purchase cost was $7. In reality, this may not necessary be the case as the price of goods do fluctuate from time to time. In Part 3, the methods commonly used by business entities to determine the unit costs of inventories will be discussed.

Once the closing inventories balance as at 31 December 2006 is determined, the following journal entries would be made to reflect the correct inventories balance: –

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 December 2006
Cost of goods sold			6,900
Inventories		6,900
(Being transfer of opening inventories to cost of goods sold account)

31 December 2006
Inventories	2,125
Cost of goods sold				2,125
(Being recognition of closing inventories)

The relevant accounts in the General Ledger of ABC Co. Ltd are as follows: –

			ABC Co. Ltd				Page 10
			General Ledger
			Inventories
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
01-Jan	Balance B/F		6,900.00	31-Dec	Cost of goods sold	GL45	6,900.00
31-Dec	Cost of goods sold	GL45	2,125.00	31-Dec	Balance C/F		2,125.00
			9,025.00				9,025.00

			ABC Co. Ltd
			General Ledger
			Trade Debtors				Page 15
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Jan	Sales	GL30	400.00	31-Dec	Balance C/F		7,825.00
31-Mar	Sales	GL30	3,000.00
30-Sep	Sales	GL30	675.00
30-Nov	Sales	GL30	3,750.00
			7,825.00				7,825.00

			ABC Co. Ltd
			General Ledger
			Trade Creditors				Page 20
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Dec	Balance C/F		950.00	31-Jan	Purchases	GL40	700.00
				31-Jul	Purchases	GL40	250.00
			950.00				950.00

			ABC Co. Ltd
			General Ledger
			Sales				Page 30
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Dec	Transfer to Income statement		7,825.00	31-Jan	Trade debtors	GL15	400.00
	Transfer to Income statement			31-Mar	Trade debtors	GL15	3,000.00
				30-Sep	Trade debtors	GL15	675.00
				30-Nov	Trade debtors	GL15	3,750.00
			7,825.00				7,825.00

			ABC Co. Ltd
			General Ledger
			Purchases				Page 40
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Jan	Purchases	GL20	700.00	31-Dec	Cost of goods sold	GL45	950.00
31-Jul	Purchases	GL20	250.00
			950.00				950.00

			ABC Co. Ltd
			General Ledger
			Cost of Goods Sold				Page 45
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Dec	Inventories	GL10	6,900.00	31-Dec	Inventories	GL10	2,125.00
31-Dec	Purchases	GL40	950.00	31-Dec	Transfer to Income Statement		5,725.00
					Transfer to Income Statement
			7,850.00				7,850.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd
Extract of Income Statement for the Year Ended 31 December 2006
	Ref	$

Sales	GL30	7,825.00	A
Cost of Goods Sold or Cost of Sales:
Opening Inventories	GL45	– 6,900.00	B
Purchases	GL45	– 950.00	C
Closing Inventories	GL45	2,125.00	D
		– 5,725.00	E = B+C-D
Gross Profit		2,100.00	F = A+E

An important point to note is for the Periodic Method of recording inventories or stocks, the Cost of Goods Sold or Cost of Sales has three components i.e. the opening inventories, the purchases during the year and also the closing inventories. This is also the formula of Cost of Goods Sold or Cost of Sales: –

Cost of Goods Sold/Cost of Sales = Opening Inventories + Purchases – Closing Inventories

Refer to Table 1, you could actually calculate the Cost of Goods Sold or Cost of Sales by multiplying the Quantity of Stock Out with the respective unit cost of the inventories as follows:-

Table 2	Stock Type A			Stock Type B			Stock Type C			Grand Total
	A	B	C = A x B	D	E	F = D x E	G	H	I = G x H	J = C + F + I
	Qty	Unit Cost	Total	Qty	Unit Cost	Total	Qty	Unit Cost	Total
		$	$		$	$		$	$	$
Stock out:
15.1.06	-50	5.00	-250.00	–	–	–	–	–	–	-250.00
21.3.06	–	–	–	-300	7.00	-2,100.00	–	–	–	-2,100.00
30.9.06	-75	5.00	-375.00	–	–	–	–	–	–	-375.00
30.11.06	–	–	–	–	–	–	-150	20.00	-3,000.00	-3,000.00
TOTAL			-625.00			-2,100.00			-3,000.00	-5,725.00

2. The Perpetual Method

Under the Perpetual Method of recording inventories, the movement of inventories during the financial period is updated regularly to the inventories account in the General Ledger. As a result of this kind of regular updates, more time and effort is required if compared with the Period Method of recording inventories. Refer to the same transactions shown in Example 1, the journal entries required using the Perpetual method of recording inventories are as follows: –

a. No double entry required. The transactions had been recorded in the General Ledger in the previous financial year.

b. 15 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Trade debtors	400
Sales				400
(Sales for January 2006)

Cost of goods sold			250
Inventories		250
(Being cost of goods sold for January 2006)

c. 20 January 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 January 2006
Inventories	700
Trade creditors		700
(Purchases for January 2006)

d. 21 March 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 March 2006
Trade debtors	3,000
Sales				3,000
(Sales for March 2006)

Cost of goods sold			2,100
Inventories		2,100
(Being cost of goods sold for March 2006)

e. 31 July 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
31 July 2006
Inventories	250
Trade creditors		250
(Purchases for July 2006)

f. 30 September 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 September 2006
Trade debtors	675
Sales				675
(Sales for September 2006)

Cost of goods sold			375
Inventories		375
(Being cost of goods sold for September 2006)

g. 30 November 2006

	Balance Sheet		Income Statement
	DR	CR	DR	CR
30 November 2006
Trade debtors	3,750
Sales				3,750
(Sales for November 2006)

Cost of goods sold			3,000
Inventories		3,000
(Being cost of goods sold for November 2006)

If you compare the above journal entries with those under the Periodic Method, the difference is for each sale transaction, the cost of goods sold or cost of sales must also be determined and recorded accordingly. This means, a systematic tracking method of the cost of inventories such as shown in Table 2 must be in place to facilitate monitoring the movement of inventories cost. In addition, the journal entries for transferring opening and closing inventories balances to the Cost of Goods Sold account as in the Periodic Method are not required. You would also notice that when ABC Co. Ltd made purchases of inventories, it was the Inventories account that was debited instead of the Purchases account under the Periodic Method. Should there be no incidence of inventories loss due to pilferage etc., the inventories account balance in the General Ledger would reflect the correct balance of closing inventories. The explanation on how stock losses are recorded and reflected will be done in other posts later. The obvious advantage of having a Perpetual Method of recording inventories over the Periodic Method is that those business entities using Perpetual Method are able to know the inventories balance at any point in time.

The relevant accounts in the General Ledger using Perpetual method of recording inventories are as follows: –

			ABC Co. Ltd				Page 10
			General Ledger
			Inventories
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
01-Jan	Balance B/F		6,900.00	31-Jan	Cost of goods sold	GL45	250.00
31-Jan	Trade creditors	GL20	700.00	31-Mar	Cost of goods sold	GL45	2,100.00
31-Jul	Trade creditors	GL20	250.00	30-Sep	Cost of goods sold	GL45	375.00
				30-Nov	Cost of goods sold	GL45	3,000.00
				31-Dec	Balance C/F		2,125.00
			7,850.00				7,850.00

			ABC Co. Ltd
			General Ledger
			Trade Debtors				Page 15
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Jan	Sales	GL30	400.00	31-Dec	Balance C/F		7,825.00
31-Mar	Sales	GL30	3,000.00
30-Sep	Sales	GL30	675.00
30-Nov	Sales	GL30	3,750.00
			7,825.00				7,825.00

			ABC Co. Ltd
			General Ledger
			Trade Creditors				Page 20
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Dec	Balance C/F		950.00	31-Jan	Inventories	GL10	700.00
				31-Jul	Inventories	GL10	250.00
			950.00				950.00

			ABC Co. Ltd
			General Ledger
			Sales				Page 30
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Dec	Transfer to Income Statement		7,825.00	31-Jan	Trade debtors	GL15	400.00
	Transfer to Income Statement			31-Mar	Trade debtors	GL15	3,000.00
				30-Sep	Trade debtors	GL15	675.00
				30-Nov	Trade debtors	GL15	3,750.00
			7,825.00				7,825.00

			ABC Co. Ltd
			General Ledger
			Cost of Goods Sold				Page 45
DEBIT				CREDIT
Date	Descriptions	Folio	$	Date	Descriptions	Folio	$
2006				2006
31-Jan	Inventories	GL10	250.00	31-Dec	Transfer to Income Statement		5,725.00
31-Mar	Inventories	GL10	2,100.00		Transfer to Income Statement
30-Sep	Inventories	GL10	375.00
30-Nov	Inventories	GL10	3,000.00
			5,725.00				5,725.00

The extract of the Income Statement of ABC Co. Ltd for the year ended 31 December 2006 is as follow: –

ABC Co. Ltd
Extract of Income Statement for the Year Ended 31 December 2006
	Ref	$

Sales	GL30	7,825.00	A
Cost of Goods Sold or Cost of Sales:	GL45	– 5,725.00	B
Gross Profit		2,100.00	C = A + B

As you can see, there is no purchases account created under the Perpetual Method.

The Income Statement

Remember in my previous post on the Balance Sheet? The Balance Sheet shows the “position” of an entity at a certain point in time. However, the Income Statement shows a different picture than the Balance Sheet – Income Statement or Profit and Loss Accounts is used to match the income/revenue generated by an entity with all the expenses/costs/losses the entity incurred over a specific period of time, normally this is done yearly to arrive at the final outcome, i.e. the Profit for the year/period. Examples of transactions that have an effect on the Income Statement are as follows:-

3. Purchase from trade creditor

Assume ABC Co. Ltd purchase goods worth $2,500 from its supplier, Top Goods Co. Ltd on credit term of 30 days. The double entry to record this transaction is as follows: –

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Purchases			$2,500
Cr Trade Creditor		$2,500

Assume the Balance Sheet of ABC Co. Ltd. BEFORE this transaction is as per Example 2 of my post, “the Balance Sheet”, the impact of this purchase transaction of $2,500 on the Balance Sheet and the Income Statement is as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	BEFORE	Impact of this purchase transaction of $2,500		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Cash at bank	10,000			10,000
	10,500			10,500
Liabilities
Trade creditor-Top Goods Co. Ltd			2,500	(2,500)
Creditor-Mr X	(500)			(500)
				(3,000)
TOTAL (Assets – Liabilities)	10,000			7,500
Owners’ Equity
Paid-up share capital	10,000			10,000
Accumulated loss		2,500		(2,500)
TOTAL	10,000			7,500



ABC Co. Limited
Income Statement for the year ended 31 December 2006
	BEFORE	Impact of this purchase transaction of $2,500		AFTER
		Dr	Cr
	$			$
Sales	–			–
Cost of Sales:-	–
Purchases	–	2,500		(2,500)

Other income	–			–
Other expenses	–			–
Loss for the year	–			(2,500)

Please take note of the following points:-

As there were no transactions affecting the Income Statement before this purchase transaction, all the items in the Income Statement have nil value.
As there was no other income statement transactions during the year ended 31 December 2006 (the meaning is-the relevant period that we are talking about here is from 1 January 2006 to 31 December 2006) except this $2,500 purchase of goods, the loss for the year is therefore $2,500.
The loss for the year of $2,500 would be reflected as Accumulated Loss in the Balance Sheet
The impact of this $2,500 purchase transaction MUST be recorded in pair i.e. one Debit (to the Accumulated Loss in this example) and one Credit (to the Trade Creditor-Top Goods Co. Ltd. in this example) to the Balance Sheet. This is the RULE of Double Entry system in accounting! It applies to ALL transactions, except for those transactions affecting items within the Income Statement e.g. reclassifying one type of expense/income to another type of expense/income or setting off an expense item with an income item (e.g. cash discounts against sales).
When you compare the Balance Sheet “Before” and “After” this $2,500 transaction, you would notice that Trade Creditor-Top Goods Co. Ltd and Accumulated Loss which both show the same amount of $2,500 are the “Impact” or “Changes”. In other words, the “Impact” or “Changes” in the Accumulated Loss (Retained earnings/profits if the entity is making profits) account in the Balance Sheet is the NET RESULT comparing the Balance Sheet between two different points in time and the complete details of this NET RESULT are shown in the Income Statement!

4. Recognition of Closing Inventories or Stock

Logically speaking, by making a purchase of $2,500 but unable to sell the goods would result in what we call inventories or closing stock in hand. In other worlds, the Balance Sheet and Income Statement shown in Example 3 above are incomplete without recording the recognition of closing inventories!

After ABC Co. Ltd. made a purchase of $2,500 from Top Goods Co. Ltd but unable to sell these batch of goods to its customer, ABC Co. Ltd would need to recognise closing inventories of $2,500 before finished preparing its Balance Sheet and Income Statement by the following double entry:-

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Inventories	$2,500
Cr Cost of sales-Closing Inventories				$2,500

The Balance Sheet and Income Statement of ABC Co. Ltd showing the impact of both the purchase of goods from Top Goods Co Ltd. and recognition of closing inventories are as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	BEFORE	Impact of $2,500 purchase transaction and recognition of closing inventories		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Inventories		2,500		2,500
Cash at bank	10,000			10,000
	10,500			13,000
Liabilities
Trade creditor-Top Goods Co. Ltd			2,500	(2,500)
Creditor-Mr X	(500)			(500)
				(3,000)
TOTAL (Assets – Liabilities)	10,000			10,000
Owners’ Equity
Paid-up share capital	10,000			10,000
Retained profit/(Accumulated loss)		2,500	2,500	–
TOTAL	10,000			10,000

ABC Co. Limited
Income Statement for the year ended 31 December 2006
	BEFORE	Impact of $2,500 purchase transaction and recognition of closing inventories		AFTER
		Dr	Cr
	$			$
Sales	–			–
Cost of Sales:-	–
Opening inventories	–			–
Purchases	–	2,500		(2,500)
Closing inventories			2,500	2,500
				–
Other income	–			–
Other expenses	–			–
Profit/(Loss) for the year	–			–

Can you see the differences by comparing the Balance Sheet and Income Statement of ABC Co. Ltd in Example 3 and Example 4. Omission of recognising the closing inventories after adjusting the purchases at year end is still a common mistake that I noticed in my auditing assignments to date!

More Examples

5. Sale of goods to customer

Assume ABC Co. Ltd sells goods worth $3,000 to a customer subsequent to 31 December 2006, let’s say on 3 of March 2007, Mr Y. The double entry to record this transaction is:-

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Trade debtor-Mr Y	$3,000
Cr Sales				$3,000

Let’s consider transaction in Example 6 below before ABC Co. Ltd closes its books for the year ended 31 December 2007 (meaning is to end its financial period and prepare a complete set of final accounts which includes the Balance Sheet and the Income Statement for the financial year ended 31 December 2007) and show the Balance Sheet and Income Statement after this sale of goods transaction.

6. Collections from debtors

ABC Co. Ltd received a cheque of $3,000 from Mr Y on 21 May 2007 and subsequently deposited the cheque into ABC Co. Ltd’s bank account. The double entry to record this transaction is as follow: –

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Cash at bank	$3,000
Cr Trade debtor-Mr Y		$3,000

Before ABC Co. Ltd. closes its books and prepares the Balance Sheet and Income Statement for the year ended 31 December 2007, the following double entry is required to be made to recognise the opening inventories for the year ended 31 December 2007:

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Cost of sales-Opening Inventories			$2,500
Cr Inventories		$2,500

The Balance Sheet and Income Statement of ABC Co. Ltd. after taking into account these 3 transactions (Sale of goods, Collection from debtor and Recognition of Opening Inventories) are as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2007
	BEFORE	Impact of the 3 double entries in Example 5 & 6		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Inventories	2,500		2,500	–
Trade debtor-Mr Y	–	3,000	3,000	–
Cash at bank	10,000	3,000		13,000
	13,000			13,500
Liabilities
Trade creditor-Top Goods Co. Ltd	(2,500)			(2,500)
Creditor-Mr X	(500)			(500)
	(3,000)			(3,000)
TOTAL (Assets – Liabilities)	10,000			10,500
Owners’ Equity
Paid-up share capital	10,000			10,000
Retained profit/(Accumulated loss)	–			500
TOTAL	10,000			10,500

ABC Co. Limited
Income Statement for the year ended 31 December 2007
	BEFORE	Impact of $3,000 sale transaction and recognition of opening inventories		AFTER
		Dr	Cr
	$			$
Sales	–		3,000	3,000
Cost of Sales:-	–
Opening inventories	–	2,500		(2,500)
Purchases	–			–
Closing inventories				–
				(2,500)
Other income	–			–
Other expenses	–			–
Profit/(Loss) for the year	–			500