According to international accounting standards and generally accepted accounting principles, every entity is supposed to prepare annual financial statements, including the following:
These statements or reports clearly explain how the business is performing financially so far.
It includes and reports every transaction that has occurred throughout the year.
After preparing financial statements, the financial department hires an audit firm that audits all the statements and makes sure it shows the true and fair view of the business. One of the major line items of financial statements is inventory.
What is inventory?
Inventory which is also known as stock, is the goods or commodities that the company sells for trading purposes. The entity holds inventory in the warehouses with the ultimate goal of reselling them.
These are current assets since inventories have a useful life of less than a year, the owner holds the risks and rewards of the goods and has a right to transfer these goods to anyone he wants.
At the end of each year, an inventory count is done at the warehouse to calculate the amount of closing inventory i.e. how much inventory is still left at the warehouse and is not sold.
It is treated as a current asset on the financial statements and is part of the cost of goods sold.
Inventory on the income statement:
The formula to calculate profit is Revenue – Cost and similar is the format of the income statement.
It reports the annual turnover first, the amount of which is extracted from the sales ledger.
As per IAS 01, gross and net profit shall be distinctly reported. Hence the cost of goods sold is deducted from the sales to calculate the gross profit.
Revenue – Cost of Goods Sold = Gross Profit
The operating expenses are deducted from the gross profit to arrive at the net profit.
In this article, since we are talking about the inventory, we will only discuss the cost of goods sold. The formula to calculate the cost of sales is as follows:
Opening Inventory + Purchases – Closing Inventory
The opening inventory is the closing inventory of the preceding year, and the amount can be extracted from previous financial statements.
The purchase amount is taken from the purchase ledger, while the closing inventory is calculated at the year’s end.
For example, if the accounting period ends on 31st December, the inventory count is done on 31st December each year.
These are valued at lower cost or NRV as per IAS 2.
Net realizable value is the difference between the selling price at which the damaged goods can be sold and any costs incurred to sell the good. The cost of goods sold is then deducted from the revenue amount.
This means that the closing inventory is indirectly added to the revenue to calculate the net profit.
Inventory on Balance Sheet:
Closing inventory is classified as a current asset since it has a useful life of less than a year and is a tangible good from which future economic benefits are expected.
The assets are reported in the order of liquidity on the balance sheet. The least-liquid item is reported the foremost, the inventory, whereas cash and bank are reported as the last current asset.
The closing inventory is reported at its cost or net realizable value, whichever is lower.
Inventory on the statement of cash flow:
Change in closing inventory is adjusted in the operating activities section of the cash flow statement.
Working capital changes are reported under the operating profit for the year to achieve net cash flow from operating activities.
An increase in closing inventory is deducted from the cash flow statement since cash is paid for purchases, but no cash has been received against such purchases, which results in a decrease in cash flow.
Similarly, a decrease in closing inventory is added to the operating profit in the operating activities section of the cash flow statement.
Inventory on the statement of changes in equity: There is no impact of inventory on the statement of retained earnings.