ACCT1110 Chap.4 The Income Statement and Inventory
The Income Statement and Inventory
A trading company's income statement carries two subtotals doing different jobs. Gross profit is net sales less cost of sales, and it answers one question only: does the product sell for enough more than it costs to buy. Everything below that line is the cost of running the business rather than the cost of the goods, and the subtotal after those is operating profit.
A thin margin with fast stock movement can be more profitable than a fat margin on goods that sit.
Net sales is gross sales after returns and allowances are deducted, which matters more than it sounds: several later measures specify net credit sales, so a question that hands you a gross figure and a returns figure is testing whether you deduct before dividing. Cost of sales, meanwhile, is not purchases.
It is opening inventory plus purchases less closing inventory, so a business can buy nothing all year and still report a large cost of sales while it clears stock.
Closing inventory then sits in two statements at once, as an asset in the balance sheet and, by subtraction, inside cost of sales. Overstate it and both profit and assets are overstated together.
That double effect is why the measurement rule matters: inventory is carried at the lower of cost and net realisable value, so a write down happens as soon as goods become obsolete rather than when they are eventually cleared. The two turnover measures that read this balance close the topic.
What this chapter covers
- 01
Two subtotals and what each one answers
- 02
Returns, allowances and net sales
- 03
The bridge from purchases to cost of sales
- 04
Why closing inventory lands in two statements
- 05
Lower of cost and net realisable value
- 06
Weighted average cost and shrinkage provisions
- 07
Inventory turnover and days on hand
- 08
Writing the improved or worsened sentence
Inventory turnover, days on hand and the comparison sentence
- +1Average inventory is ($52,400 plus $61,900) divided by 2 = $57,150. Use the average, because cost of sales accumulated across the whole year while a closing balance is one date.
- +1Turnover is $398,700 divided by $57,150 = 6.98 times.
- +1Days on hand are 365 divided by 6.98 = 52.29 days. Carry the unrounded turnover into this division, or state that the rounded figure was used.
- +1Write the comparison: turnover fell from 8.4 times to 6.98, so the average holding period lengthened from about 43 days to about 52. That is a deterioration, because more cash is tied up per dollar of sales.
Key terms
- Gross profit
- Net sales less cost of sales, the margin available before any operating cost is met. It isolates the trading margin from the cost of running the business.
- Net sales
- Gross sales after sales returns and allowances are deducted, because those sales did not ultimately happen at the invoiced amount.
- Cost of sales
- Opening inventory plus purchases less closing inventory, which is what was sold rather than what was bought.
- Net realisable value
- Expected selling price less the costs of making the sale. Inventory is carried at this figure whenever it is lower than cost.
- Weighted average cost
- A cost formula that averages the cost of identical units held, used in place of tracking individual items through a large inventory.
- Inventory turnover
- Cost of sales divided by average inventory, counting how many times the stock on hand is sold and replaced in a year.
- Days in inventory
- 365 divided by inventory turnover, expressing the same fact as an average holding period in days.
The Income Statement and Inventory FAQ
Why is closing inventory deducted in arriving at cost of sales?
Because cost of sales measures what left the business, not what came in. Everything available for sale is opening inventory plus purchases; whatever is still on the shelf at the end did not contribute to this period's sales, so it is taken back out. That is also why an overstated closing figure makes cost of sales too small and profit too large at the same time.
What does lower of cost and net realisable value mean in practice?
Compare what you paid to get the goods where they are against what you expect to receive for them less the cost of selling them, and carry the smaller figure. Goods costing eighty dollars that will clear for thirty are written down to thirty now, not when they are eventually sold. Large retailers state this policy explicitly and add a provision for expected shrinkage.
Should turnover be calculated on closing inventory or average inventory?
On average inventory, because the numerator is a flow that accumulated over twelve months while a closing balance is a single date. Mixing the two produces a figure that moves whenever the year end happens to fall at an unusual point in the stock cycle, and the line showing the average is usually worth a mark of its own.
Does a higher turnover always mean better management?
Not automatically. Faster movement frees cash, but a turnover that rises because stock has been run down can leave the business unable to supply. Read it beside the gross profit ratio: rising turnover with a falling margin suggests goods are being discounted to clear, which is a very different story from rising turnover at a stable margin.
Exam move
Rehearse the income statement top down until the order of the lines is automatic, because every ratio in the final topic pulls figures out of a statement laid out exactly that way. Write out a short statement from raw figures, compute the gross profit ratio from it, and check the arithmetic in one line.
For the inventory measures, drill the pair together rather than separately.
They are the same fact in two units, so if you can convert between them in your head you can sense check either one. And practise the written comment on its own: direction, size, then one consequence, then two causes that could be checked against the company's own records.
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