I am trying to understand what we need closing inventory adjustment for but I have troubles with it.
I have 1000 pounds debit balance on my finished goods account. This is balance sheet account. I sell part of my finished goods. Cost of goods sold is 700 pounds. Closing balance on my finished goods account is 300 pounds. I have 300 pounds on my balance sheet and 700 pounds in my income statement.
Why do I need to make closing inventory adjustment if I already have unsold goods in balancesheet (to me it is ok ) and cost of good sold in income statement. Everything seems to be ok .
What is closing inventory adjustment good for in situation described above ?
well, I think I confused manufacturing business with merchandising business. Term ' inventory' is related to merchandising business. They purchase goods for resale and what is left at the year end is called closing inventory. Purchases are income statement item. Not all sold purchases generated revenue. In order to arrive at cost of goods sold we should exclude from all purchases this part that didn't generate revenue (closing inventory)
But manufacturing businesses too have probably finished goods unsold. What do manufacturers do in order to distinguish between costs that generated revenue and those costs that didn't generate revenue ?
Production costs are in balance sheet before product is sold. How do people know which production costs generated revenue and which didn't generate revenue ?
-- Edited by rafapak on Friday 6th of March 2020 04:31:36 PM
-- Edited by rafapak on Friday 6th of March 2020 04:35:49 PM
I think I see why you asked this, because the manufacturing account doesn't deal with finished goods, just raw materials and work in progress. Finished goods are dealt with in the trading account, which shows the gross profit and the closing inventory for finished goods.
The trading account shows the costs of finished goods sold and the gross profit, and the gross profit will go into the income statement at the accounting year end.
The manufacturing account includes values for the WIP and raw materials to be used in production and these are included in the balance sheets as assets. The value of the closing inventory for unsold finished goods from the trading account will also be included in the balance sheet, as an asset.
These financial statements form a set of final accounts at year end for a manufacturing business, and it sounds like it is final accounts that you are studying or looking at. The costs of sales in the income statement at the accounting year end is only for the finished goods that have been sold.
Have you covered the matching principle in accounting in your course ? Expenses are required to be reported in the same period as the income that they relate to is earned in final accounts, and its this accounting principle that underpins the above.
Management accounts are internal to the business and are not governed by accounting principles or legislation. These reports can be in any format that is useful to the business, and so in these reports you might see a total cost for production for the month that includes both finished goods and WIP, and it may be broken down by product line.
