According to the international accounting standards and generally accepted accounting principles, every entity is supposed to prepare annual financial statements including the following:
These statements or reports are made in order to provide a clear understanding of how the business is performing financially so far.
It includes and reports each and every transaction that has occurred throughout the year.
After the preparation of financial statements by the financial department, an audit firm is hired 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 the inventory.
What is inventory?
Inventory which is also known as stock are the goods or commodities that is sold by the company for trading purposes. Inventory is held by the entity 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 also makes a part of cost of goods sold.
Inventory on income statement:
The formula to calculate profit is Revenue – Cost and similar is the format of income statement.
It reports the annual turnover first, the amount of which is extracted from the sales ledger.
As per IAS 01, the gross profit and net profit shall be distinctly reported. Hence the cost of goods sold is deducted from the sales in order to calculate the gross profit.
Revenue – Cost of Goods Sold = Gross Profit
The operating expenses are then deducted from the gross profit with the aim of arriving at the net profit.
In this article, since we are talking about the inventory, we will discuss the cost of goods sold only. The formula to calculate 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 purchases amount is taken from the purchase ledger while the closing inventory is calculated at the year end.
For example, if the accounting period ends at 31st December, the inventory count is done at 31st December each year. These are valued at lower of 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 in order 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 in order 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 which is 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 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 with the aim of achieving 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 operating activities section of the cash flow statement. Inventory on statement of changes in equity: There is no impact of inventory on statement of retained earnings.