A trader’s profit depends on the cost of the goods it sold, not the cost of the goods it bought. The two differ by the change in inventory.
This topic explains how inventory is recorded and how cost of sales is found, under the periodic system used at the year end and the perpetual system that tracks every movement, how to correct an inventory count taken on a different date from the reporting date, and the entries under each system.
Inventory adjustments sit inside almost every final accounts question and appear in Section A in about half the diets, usually as a calculation of cost of sales, purchases, closing inventory or gross profit. A question on year-end adjustments normally uses the periodic method, but the perpetual method is examinable in its own right. Read the trial balance topic, where closing inventory was first introduced. The next topic covers how inventory is valued.
In 30 seconds
Gross profit needs Cost of sales, found from opening inventory, purchases and closing inventory. Periodic system: purchases go to a Purchases account. At the year end the stock is counted and valued, and Cost of sales = opening inventory + purchases − closing inventory. Closing inventory is Dr Inventory, Cr Cost of sales.
Perpetual system: one inventory account records every receipt and issue, so the balance is always the inventory held and there is no purchases account. If the count is not on the reporting date, adjust the counted value for the movements in between. Goods taken by the owner are drawings.
Why inventory is recorded
To prepare a statement of profit or loss, gross profit is found by comparing the sale proceeds with the cost of the items sold. This applies the accruals (matching) concept. It needs opening inventory, purchases and closing inventory. There are two main methods of recording inventory, the periodic system and the perpetual system. Each uses an inventory account, but in different roles.
The periodic inventory method
The periodic inventory method, or period-end method, uses two ledger accounts: a Purchases account that records all purchases in the year, and an Inventory account that records the value of inventory at the beginning and the end of the year.
Year 1. The business has no opening inventory. All purchases are debited to purchases: Dr Purchases, Cr Cash or payables. At the year end the purchases figure is transferred to cost of sales: Dr Cost of sales, Cr Purchases. Purchases are not the same as cost of sales, because some of the goods bought are still held. The business counts every item, and values it, usually at cost.
That is the Closing inventory. It is recognised as an asset and as a credit in the statement of profit or loss, where it reduces the cost of sales:
Dr Inventory (statement of financial position), Cr Cost of sales (statement of profit or loss)
The credit may go to a statement of profit or loss inventory account later transferred to cost of sales, or straight to cost of sales. Either way it reduces cost of sales. The debit is carried into Year 2 as an asset.
Year 2. Closing inventory of Year 1 is the opening inventory of Year 2. At the year end both the opening inventory and the purchases are transferred to cost of sales: Dr Cost of sales, Cr Purchases and Dr Cost of sales, Cr Inventory (the removal of the opening inventory). Then the closing inventory is recognised as above. So:
| Cost of sales | ₦ |
|---|---|
| Opening inventory (a debit) | X |
| Purchases (a debit) | X |
| X | |
| Closing inventory (a credit) | (X) |
| Cost of sales | X |
Port Harcourt Trading, for instance, has opening inventory of ₦10,000, purchases of ₦30,000 and closing inventory of ₦12,000. Cost of sales is 10,000 + 30,000 − 12,000 = ₦28,000. In the period-end system the double entries are between the inventory account and the statement of profit or loss. Opening inventory is an expense, so debit the statement of profit or loss and credit the inventory account.
Closing inventory is an asset, so debit inventory and credit the statement of profit or loss.
When the count is not on the reporting date
It may not be possible to count on the reporting date. The count may be a few days before or after, so the book value at the reporting date must be reconciled with the physical count.
| Item | Cut-off date after the reporting date | Cut-off date before the reporting date |
|---|---|---|
| Sales between the dates | Add back at cost | Include in inventory, at the lower of cost and net realisable value |
| Purchases between the dates | Exclude from inventory | Include if received before the reporting date |
| Sales returns (returns inwards) | Exclude, at cost | Include, at cost |
| Purchase returns (returns outwards) | Include | Exclude |
| Goods received on sale or return | Exclude if received after the reporting date | Include if not returned by the reporting date |
| Goods sent to a consignee on sale or return | Exclude if not returned by the reporting date | Exclude unless returned before the reporting date |
| Inventory sheets | Under-casting included, over-casting excluded | Over-casting excluded, under-casting included |
Example. The reporting date is 31 December. The count on 8 January values inventory at ₦8,400,000. Between 1 and 8 January sales at a mark-up of 25% on cost were ₦1,500,000, purchases received were ₦640,000, sales returns at the same mark-up were ₦300,000, and goods held on sale or return from a supplier were ₦400,000, included in the count.
- Cost of the sales is 1,500,000 × 100/125 = 1,200,000.
- Cost of the returns is 300,000 × 100/125 = 240,000.
- Inventory at 31 December = 8,400,000 + 1,200,000 − 640,000 − 240,000 − 400,000 = ₦8,320,000.
The goods from the supplier are not owned, so they come out.
The perpetual inventory method
With the perpetual inventory method a single account records all inventory movements. A record is kept of every receipt at cost and every issue to cost of sales. Each issue is costed at actual cost if that can be found, or by a valuation method. Because purchases are recorded in the inventory account, There is no purchases account.
At any time the balance is the value of inventory held. Every transaction that adjusts inventory cost is recorded in it: purchases, freight, returns to suppliers, returns from customers, issues, and losses.
The entries under each system
| Event | Periodic system | Perpetual system |
|---|---|---|
| Opening inventory | Closing inventory of the last period, brought forward | Closing balance on the inventory account |
| Purchase | Dr Purchases, Cr Payables or cash | Dr Inventory, Cr Payables or cash |
| Freight paid | Dr Carriage inwards, Cr Payables or cash | Dr Inventory, Cr Payables or cash |
| Return to a supplier | Dr Payables, Cr Purchase returns | Dr Payables, Cr Inventory |
| Sale | Dr Receivables, Cr Sales | Dr Receivables, Cr Sales, and Dr Cost of goods sold, Cr Inventory |
| Goods returned by a customer | Dr Sales returns, Cr Receivables | Dr Sales returns, Cr Receivables, and Dr Inventory, Cr Cost of goods sold |
| Normal loss | No double entry | Dr Cost of goods sold, Cr Inventory |
| Abnormal loss | Dr Abnormal loss, Cr Purchases | Dr Abnormal loss, Cr Inventory |
| Closing inventory | Counted, valued, Dr Inventory, Cr Cost of sales | The balance on the inventory account |
The ideas in more depth
Goods taken by the owner. Under the periodic system, inventory taken for private use is Dr Drawings, Cr Purchases, because some of the goods bought were not for resale. Under perpetual it is Dr Drawings, Cr Inventory. In the cost of sales formula, goods taken by the owner are not deducted as sold. Periodic versus perpetual. Periodic gives cost of sales only at the year end.
Perpetual gives it with every sale and shows losses at once. The check. Closing inventory counted against the perpetual balance shows theft or damage. Cost of sales and gross profit. Gross profit is sales less cost of sales. If a margin or mark-up is given, work back to cost: with a mark-up of 25% on cost, cost = sales × 100/125. With a margin of 20% on sales, cost = sales × 80/100.
Worked example: Aba Hardware
Scenario. Aba Hardware had opening inventory of ₦480,000, purchases of ₦3,600,000, carriage inwards of ₦90,000, purchase returns of ₦140,000 and sales of ₦5,200,000. Closing inventory at cost was ₦520,000. The owner took goods costing ₦25,000 for private use. Required: the cost of sales, gross profit and the entries.
- Owner’s goods. Dr Drawings 25,000, Cr Purchases 25,000.
Net purchases = 3,600,000 − 25,000 = 3,575,000. - Cost of sales.
Opening inventory 480,000 + purchases 3,575,000 + carriage inwards 90,000 − purchase returns 140,000 = 4,005,000, less closing inventory 520,000 = 3,485,000. - Gross profit.
5,200,000 − 3,485,000 = ₦1,715,000. - Closing entries. Dr Cost of sales 480,000, Cr Inventory 480,000 (remove opening). Dr Cost of sales 3,575,000, Cr Purchases 3,575,000. Dr Cost of sales 90,000, Cr Carriage inwards 90,000. Dr Purchase returns 140,000, Cr Cost of sales 140,000. Dr Inventory 520,000, Cr Cost of sales 520,000 (closing inventory).
- Check.
Cost of sales account: debits 480,000 + 3,575,000 + 90,000 = 4,145,000.
Credits 140,000 + 520,000 = 660,000.
Balance 3,485,000.
It agrees. - Perpetual version. Opening 240,000, purchases 1,800,000, carriage 36,000, returned to suppliers 60,000, sold at cost 1,650,000, returns from customers 45,000, normal loss 12,000.
Closing = 240,000 + 1,800,000 + 36,000 − 60,000 − 1,650,000 + 45,000 − 12,000 = ₦399,000.
Common mistakes in the exam
- Deducting opening inventory instead of adding it in the cost of sales formula.
- Forgetting carriage inwards, which is part of the cost of purchases, or deducting purchase returns twice.
- Treating goods taken by the owner as sales or an expense. They are drawings, credited to purchases.
- Applying a mark-up to the wrong base. Mark-up is on cost, margin on sales.
- Adding goods on sale or return from a supplier to the inventory.
- Crediting the sale of goods returned by customers twice in a perpetual account.
- Putting closing inventory only in the statement of financial position, and forgetting the credit to cost of sales.
Quick revision
- Cost of sales = opening inventory + purchases (net of returns, plus carriage) − closing inventory.
- Periodic: purchases account, count at year end. Perpetual: one inventory account, no purchases account.
- Closing inventory: Dr Inventory, Cr Cost of sales.
- Count date after the reporting date: add back sales at cost, deduct purchases and sales returns, deduct sale-or-return goods not owned.
- Owner’s goods: Dr Drawings, Cr Purchases.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Opening inventory ₦200,000, purchases ₦900,000 and closing inventory ₦250,000 give cost of sales of:
- ₦950,000
- ₦1,350,000
- ₦450,000
- ₦850,000
Show the answer
D. 200,000 + 900,000 − 250,000 = 850,000.
Question 2. Cost of sales is ₦95,000, opening inventory ₦12,500 and closing inventory ₦30,000. Purchases are:
- ₦77,500
- ₦112,500
- ₦107,500
- ₦137,500
Show the answer
B. 95,000 + 30,000 − 12,500 = 112,500.
Question 3. Closing inventory is recorded by:
- Dr Inventory, Cr Cost of sales
- Dr Cost of sales, Cr Inventory
- Dr Purchases, Cr Inventory
- Dr Inventory, Cr Purchases
Show the answer
A. Closing inventory reduces cost of sales: Dr Inventory (an asset), Cr Cost of sales.
Question 4. Under the periodic system the owner takes goods for private use. The entry is:
- Dr Purchases, Cr Drawings
- Dr Sales, Cr Drawings
- Dr Drawings, Cr Purchases
- Dr Inventory, Cr Purchases
Show the answer
C. Goods taken by the owner are drawings: Dr Drawings, Cr Purchases.
Question 5. Sales are ₦2,640,000 with a gross profit of 25% of sales. Opening inventory ₦495,000, purchases ₦1,870,000, carriage inwards ₦11,000. Closing inventory is:
- ₦385,000
- ₦396,000
- ₦660,000
- ₦792,000
Show the answer
B. Cost of sales = 75% × 2,640,000 = 1,980,000. Goods available = 495,000 + 1,870,000 + 11,000 = 2,376,000. Closing = 2,376,000 − 1,980,000 = 396,000.
Question 6. Under the perpetual system there is no:
- Inventory account
- Purchases account
- Cost of goods sold account
- Sales account
Show the answer
B. Purchases are debited to inventory.
Question 7. The count is made after the reporting date. Sales between the dates, at cost, are:
- Deducted
- Ignored
- Added to sales
- Added back to the counted value
Show the answer
D. Goods sold after the reporting date were still on hand at that date, so their cost is added back to the counted value.
Question 8. Goods held on sale or return from a supplier are:
- Always included
- Treated as sales
- Not owned and excluded from inventory
- Capital
Show the answer
C. Goods on sale or return are not owned by the business until accepted, so they are excluded from inventory.
Question 9. A normal loss under the perpetual system is recorded as:
- Dr Inventory, Cr Cost of goods sold
- No entry
- Dr Cost of goods sold, Cr Inventory
- Dr Drawings, Cr Inventory
Show the answer
C. A normal loss is a cost of sales: Dr Cost of goods sold, Cr Inventory.
Question 10. A mark-up of 25% on cost means cost is what share of sales?
- 80%
- 75%
- 125%
- 25%
Show the answer
A. Cost = 100/125 of sales = 80%.
Section B style: written questions
Question 11 (10 marks). (a) Distinguish the periodic from the perpetual inventory system. (4 marks) (b) Give the entry for a purchase and for a sale of goods under each system. (6 marks)
Question 12 (20 marks). Sapele Traders had sales of ₦9,400,000, purchases of ₦5,100,000, carriage inwards of ₦140,000, purchase returns of ₦210,000 and opening inventory of ₦760,000. Closing inventory at cost is ₦880,000. The reporting date is 31 December, but the count was made on 10 January. On the count date inventory was valued at ₦480,000, and between 1 and 10 January sales were ₦960,000 at a mark-up of 20% on cost, purchases received ₦300,000, and sales returns ₦120,000 at the same mark-up.
(a) Calculate the cost of sales and the gross profit. (6 marks) (b) Give the closing entries for inventory. (6 marks) (c) Calculate the inventory at 31 December from the count, and show that it agrees with the closing inventory used in (a). (8 marks)
A further written question
Question 13 (10 marks). Opening inventory was ₦150,000. Purchases were ₦900,000, carriage inwards ₦24,000 and returns to suppliers ₦30,000. Goods that cost ₦840,000 were sold, customers returned goods costing ₦18,000, and a normal loss of ₦6,000 occurred. (a) Prepare the inventory account under the perpetual system. (7 marks) (b) State the cost of goods sold. (3 marks)
Model answers
Show the model answer to Question 11
(a) Periodic: purchases go to a purchases account and inventory is counted and valued at the year end to find cost of sales. Perpetual: one inventory account records every receipt and issue, so the balance is the inventory held and cost of goods sold is recorded at each sale. (b) Periodic: purchase Dr Purchases, Cr Payables or cash. Sale Dr Receivables, Cr Sales.
Perpetual: purchase Dr Inventory, Cr Payables or cash. Sale Dr Receivables, Cr Sales, and Dr Cost of goods sold, Cr Inventory.
Show the model answer to Question 12
(a)
- Cost of sales.
760,000 + 5,100,000 + 140,000 − 210,000 − 880,000 = 4,910,000. - Gross profit.
9,400,000 − 4,910,000 = ₦4,490,000.
(b) Dr Cost of sales 760,000, Cr Inventory 760,000 (remove opening). Dr Cost of sales 5,100,000, Cr Purchases. Dr Cost of sales 140,000, Cr Carriage inwards. Dr Purchase returns 210,000, Cr Cost of sales. Dr Inventory 880,000, Cr Cost of sales 880,000.
(c)
- Cost of sales between the dates.
960,000 × 100/120 = 800,000. - Cost of returns.
120,000 × 100/120 = 100,000. - Inventory at 31 December = 480,000 + 800,000 − 300,000 − 100,000 = ₦880,000, which agrees with the closing inventory used in (a).
Show the model answer to Question 13
(a) Inventory account (perpetual system). Debit side: opening balance 150,000; purchases 900,000; carriage inwards 24,000; goods returned by customers, at cost, 18,000. The total is 1,092,000. Credit side: returns to suppliers 30,000; cost of goods sold 840,000; normal loss 6,000, which is charged to cost of goods sold; closing balance ₦216,000. The total is 1,092,000.
(b) Cost of goods sold. 840,000 recorded on the sales, less 18,000 reversed when the customers returned goods (Dr Inventory, Cr Cost of goods sold), plus the normal loss of 6,000 (Dr Cost of goods sold, Cr Inventory) = ₦828,000.
Pathfinder on Inventory: year-end adjustments, periodic and perpetual systems
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Asks for sales revenue from opening inventory, purchases, closing inventory and a gross margin of 40%.
Revise first: The ideas in more depth
From the previous syllabus. Asks for purchases from cost of sales, opening inventory and closing inventory.
Revise first: The periodic inventory method
From the previous syllabus. Asks for closing inventory from opening inventory, purchases, carriage inwards, sales and a gross profit of 25% of sales.
Revise first: The periodic inventory method
From the previous syllabus. Asks for the entry when a sole trader on the end-period system takes inventory for personal use.
Revise first: The ideas in more depth
From the previous syllabus. Question 14 asks for gross profit from opening inventory, closing inventory, purchases and a 5% margin. Question 19 asks which items are deducted from goods available for sale to reach cost of sales.
Revise first: The periodic inventory method
From the previous syllabus. Asks for cost of sales or closing inventory from opening and closing figures.
Revise first: The periodic inventory method
Question 14 of May 2023 asks for the cost of sales from a 10% mark-up. Question 7 of May 2024 asks how much inventory the owner withdrew. Question 15 of November 2023 asks for the accounting equation after the owner takes cash and inventory.
Revise first: The ideas in more depth
An item most diets asks for cost of sales, purchases, closing inventory or gross profit from given figures, often with a margin or mark-up, or for the entry for goods taken by the owner. Check Section A of every diet you practise.
Revise first: The periodic inventory method
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2014, November Diet, 2016, November Diet, 2017, November Diet, 2018, May Diet, 2021, May Diet, 2022, May Diet, 2023, November Diet, 2023 and May Diet, 2024 (the later ones are not all on the previous syllabus). Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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