In accounting, stock or inventory is an asset to the business, firm or company. The cash value of the stock is shown on the balance sheet. The change in inventory helps in the calculation of the cost of goods sold. The calculation of the cost of goods sold is very important as it is used in the calculation of a business’s profit. So, in this article, let's delve deeper into understanding the fundamentals of closing stock, the calculation methods of closing stock and other relevant details.
Did you know?
Closing Stock is shown on the credit side of a trading account and the asset side of a balance sheet.
What is Closing Stock?
The inventory that stays with a business/firm at the end of a financial year is known as the closing stock. It comprises the raw materials purchased, stock of finished products, and work-in-progress. The closing stock can be evaluated by manually counting the inventory. Adopting a perpetual inventory system and cycle counting too can serve the purpose.
What is the Closing stock comprised of?
The closing stock comprises three different types of materials. They are:
- Raw material: It is used in the production process of the material that is ready to be manufactured into finished products.
- Work-in-progress: It refers to the materials that are in the process of being manufactured into final products.
- Finished products: These goods have gone through the manufacturing process and are ready for sale.
What is the Closing Stock Formula?
Closing stock is the unsold stock remaining with the company at the end of a business year. Closing stock can be calculated by following the perpetual inventory system or manually counting the remaining stock. The closing stock/inventory formula is provided below:
Closing Stock= Opening stock / inventory Purchases - Cost of goods sold
Where,
Opening stock/inventory= Previous years remaining stock/inventory
Purchases= Purchases made in the current financial year or the goods manufactured
Cost of Goods sold= the cost of the products manufactured or sale of the product.
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Valuation of closing stock
To calculate the closing stock/inventory, the value of new purchases is added to the opening stock. Then the cost of goods sold is subtracted from it. The remaining is the closing stock valuation of that particular business year. The lowest value of goods or the market price determine the closing stock. To calculate the closing stock/inventory by physical count seems to be an obvious method, but this method is not practical, so an estimated method is used.
The recorded value of closing stock can be estimated through the following methods:
- Retail Inventory method
- Weighted average method.
- First in, first-out method (FIFO)
- Last in, first-out method (LIFO)
- Lower of Cost or Market Rule
1. Using the Gross Profit Method
Below are the steps to calculate the closing stock through the gross profit method:
Step 1: Add the cost of opening stock to the cost of purchases during the period. This will amount to the cost of goods that are available for sale.
Step 2: Multiply the Gross Profit percentage by the number of sales to reach the estimated cost of the sales.
Step 3: Subtract the cost of goods available for sale from the cost of goods sold. The remaining is the closing stock.
2. Using the Retail Method
Below are the steps to calculate the closing stock through the retail method:
- Computing the cost-to-retail percentage.
Cost-To-Retail Percentage = Cost / Retail price
- Then, calculate the cost of goods that are available for sale.
Cost of Good Available for Sale = Cost of Opening Stock plus Cost of Purchases.
- Calculate the cost of sales that occurred during the period
Cost of Sales = Sales x Cost-To-Retail Percentage
- Calculation of closing stock
Closing Stock = Cost of goods available for sale – Cost of sales during the period.
3. First In, First Out (FIFO) Method
Under the first-in, first-out method, when a unit is sold, the cost of the oldest unit in the stock is assigned to it. In an inflation scenario, this action results in the goods sold at a lower cost and hence more profit.
4. Last In, First Out (LIFO) Method
In the last-in, first-out method, the result is just the opposite. In this case, when a unit is sold, the cost of the newest unit in inventory is assigned. Again, in an inflation scenario, this action shows a higher cost of the goods sold and lower profits.
5. Lower of Cost or Market Rule
After the value of the closing stock is calculated, it might be further adjusted according to the lower cost or market rule. This rule states that an inventory good must be recorded at the lower of the two- its cost or the current market value. Usually, the lower cost or market rule is used during the annual audit period to comply with the generally accepted accounting principles.
Closing Stock in the Balance Sheet
The closing stock is shown as a business asset on the balance sheet. This is adjusted with the amount of purchases that are put to the debit of the trading account. The adjusted purchase is sometimes shown in the trial balance, i.e., the Opening Stock and Closing Stock are adjusted through this purchase. In such a case, both the Adjusted purchase account and the closing stock account are shown in the Trial balance.
What is the effect of Pricing Method on the Closing Stock?
The pricing method adopted by a company invariably affects the finances and profits of a company. If the business chooses the LIFO (last in, First out) method and the inflation continues to rise, the cost of sold products will increase as well. Thus, it would bring down the gross profit and taxes. This is why businesses prefer the LIFO accounting approach over FIFO (first in, first out). Also, using the LIFO method will result in a higher closing stock in the Balance sheet than the FIFO method.
The manner of stock management has a major impact on the ratios. When LIFO is used, the current ratio (current assets/current liabilities) will be high as the number of current assets increases. If FIFO is applied, the inventory turnover ratio (Sales/Average Inventory) will decrease.
Why is a closing stock calculation done?
- Closing stock is important to calculate to ascertain that actual stocks match the sales and purchases during the accounting period. Also, this detail is essential during an audit.
- If the final transactions and the ending inventory match, it shows that the business has managed to remain within its budget.
- This will also clarify if there are any problems with the production cost.
- The closing stock calculation is also important because the closing stock is carried over to the new accounting period.
- An inaccurate stock valuation would carry the financial discrepancy into the new accounting period.
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Conclusion
Closing stock is an integral component in accounting. It aids in understanding the amount of unsold stock by a business. Understanding the closing stock, a company can make relevant decisions about it, which would be reflected in the business's ledger. Using the different calculation methods, a business can identify its closing stock, which has been highlighted in this article. We hope this article has been of help to you in providing relevant details about Closing stock/inventory in a business.
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