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So far we have come across opening inventory in the preparation of a simple statement of financial position in Chapter 2 and have learned closing inventory， carriage inwards and outwards in chapter 3.They all relate to the calculation of cost of goods sold， which sometimes can be stated as‘cost of sales’． Here we will do some recap first and then explore more details of the cost of goods sold．
You already know how to calculate the cost of goods sold for a retailing company． If we consider the case of a manufacturing company， a more general formula for cost of goods sold is found as below．
To match ‘sales’ and the ‘cost of goods sold’， it is necessary to adjust the cost of goods manufactured or purchased to allow for increases or decrease in inventory levels during the period．
A trader might be unable to sell all the goods that they purchase， because a number of things might happen to the goods before they can be sold． For example：
·Goods might be lost or stolen．
·Goods might be damaged， become worthless and so be thrown away．
·Goods might become obsolete or out of fashion； These might be thrown away， or sold off at a very low price in a clearance sale．
When goods are lost，stolen or thrown away as worthless， the business will make a loss on those goods because their ‘sales value’ will be nil ．
Similarly， when goods lose value because they have become obsolete or out of fashion， the business will make a loss if their clearance sales value is less than their cost． For example， if goods which originally cost ￡ 500 are now obsolete and could only be sold for ￡ 150， the business would suffer a loss of ￡ 350.
If， at the end of an accounting period， a business still has goods in inventory which are either worthless or worth less than their original cost， the value of the inventories should be written down to：
·Nothing， if they are worthless．
·Their net realisable value（we will discuss this concept in section 4.3）， if this is less than their original cost．
This means that the loss will be reported as soon as the loss is foreseen， even if the goods have not yet been thrown away or sold off at a cheap price． This is an application of the prudence concept．
The costs of inventory written off or written down should not usually cause any problems when calculating the gross profit of a business， because the cost of goods sold will include the cost of inventories written off or written down， as the following example shows．
W． Lucas， trading as Fairlock Fashions， ends his financial year on 31 March． At 1 April 20×5 he had goods in inventory valued at ￡ 8，800.During the year to 31 March 20×6， he purchased goods costing ￡ 48，000.Fashion goods which cost ￡ 2，100 were still held in inventory at 31 March 20×6， and W． Lucas believes that these could only now be sold at a sale price of￡ 400.The goods still held in inventory at 31 March 20×6 （including the fashion goods） had an original purchase cost of ￡ 7，600.Sales for the year were ￡ 81，400.
Requirement
Calculate the gross profit of Fairlock Fashions for the year ended 31 March 20×6.
Solution
Initial calculation of closing inventory values：
Gross profit calculation is shown in Exhibit 4.1：
Exhibit 4.1
By using the figure of ￡ 5，900 for closing inventories， the cost of goods sold automatically includes the inventory written down of ￡ 1，700.
Where a material amount of inventory has been stolen or destroyed， including their cost in gross profit will give a very distorted idea of the business's basic profitability：
·Purchases will include the cost of goods that could not be sold， so the accrual principle is broken， yet they are not in closing inventory either， so it will look as if the business's gross margin on sales has fallen catastrophically．
·There may be an amount of income as a result of an insurance claim， which cannot be included in cost of sales．
These problems are overcome by taking the cost of goods stolen or destroyed out of purchases ， and including it under expenses ． An insurance claim is treated as other income in calculating net profit； if it has not yet been received in the form of cash it is disclosed as ‘other receivables’ on the statement of financial position． It should only be recorded if it is reasonably certain that the amount will be received， which will be evidenced by having a valid insurance policy and confirmation from the insurer that the claim will be settled．
Farita had ￡ 15，000 of inventory as at 1 January 20×2.During the year to 31 December 20×2 she purchased inventory for ￡ 98，000， incurring carriage inwards of ￡ 150.She made sales of ￡ 150，000， incurring carriage outwards to her customers of ￡ 2，400.At 31 December 20×2 she realises that she has inventory costing only ￡ 200 left； goods costing ￡ 18，000 have been stolen．
Requirement
Prepare Farita's statement of profit or loss assuming：
Scenario 1：Farita has relevant insurance and her insurer has agreed to pay her claim for 75％ of the cost．
Scenario 2：Farita does not have any insurance．
Solution
Farita's statement of profit or loss under scenario 1 ＆2 is shown in Exhibit 4.2.
Exhibit 4.2
Business trading is a continuous activity， but accounting statements must be drawn up at a particular date． In preparing a statement of financial position it is necessary to ‘freeze’the activity of a business to determine its assets and liabilities at a given moment． This includes establishing the quantities of inventories on hand．
In simple cases， usually when a business holds easily counted and relatively small amounts of inventory， quantities of inventories on hand at the reporting date can be determined by physically counting them in an inventory count at that date． This kind of system is known as‘periodic inventory valuation’ system．
In more complicated cases， where a business holds considerable quantities of varied inventory， an alternative approach to establishing quantities is to maintain continuous inventory records ．This means that the accounting system keeps a record for each line of inventory item，showing purchases and issues from the stores， and a running total． A few inventory line items are counted each day to make sure their record cards are correct—this is called a ‘continuous’count because it is spread out over the reporting period rather than completed in one count at a designated time． This kind of system is also known as‘perpetual inventory records’ system．
If a business adopts ‘periodic inventory valuation’ system， it usually keeps an inventory account． This inventory account is only ever used at the end of an accounting period ，when the business counts up and values the inventory in hand． Let's recap the ledger entries for opening and closing inventories．
（1） When an inventory count is made ，the business will have a value for its closing inventory，and the double entry is：
However， rather than show the closing inventory as a‘plus’ value in the trading account（by adding it to sales） it is usual to show it as a‘minus’ figure in arriving at cost of goods sold （therefore， in some textbooks， the credit entry goes to Cost of Goods Sold account）． This is illustrated in Chapter 3.The debit balance on inventory account represents an asset， which will be shown as part of current assets in the statement of financial position．
（2）Closing inventory at the end of one period becomes opening inventory at the start of the next period． The inventory account remains unchanged until the end of the next period，when the value of opening inventory is taken to the trading account．
