Closing stock: why your profit is wrong without it
Purchases are a cost only when the goods are sold. Leave out what is still on the shelf and a profitable month reads as a heavy loss. A worked example, and what to count.
Buy ₹40 lakh of cloth in September and sell a quarter of it, and the month looks ruinous on any statement that charges the purchases and credits nothing for what is still on the shelf. The goods did not vanish. They are an asset, and until they are sold the cost of them is not a cost of anything.
The same month, both ways
| Stock left out | Stock counted | |
|---|---|---|
| Sales | 15,00,000 | 15,00,000 |
| Purchases | 40,00,000 | 40,00,000 |
| Less: closing stock | — | 30,00,000 |
| Cost of goods sold | 40,00,000 | 10,00,000 |
| Gross profit / (loss) | (25,00,000) | 5,00,000 |
Nothing about the business changed between the two columns. One of them simply forgot that three-quarters of the cloth is still there.
Where it goes wrong
Not in the arithmetic. It goes wrong when one statement is read on its own. A Trading account credits closing stock as a matter of course. A Profit and Loss drawn without the Trading account above it has to carry the stock itself — opening on the debit side, closing on the credit. Drop it, and the bottom line disagrees with the Balance Sheet beside it by exactly the stock.
One figure, two statements The profit on your Profit and Loss and the current-year profit on your Balance Sheet must be the same number. If they differ, look first for the stock, then for a head sitting on the wrong side.
Goods that are yours but not with you
Cloth at the mill and cloth with a job worker have left the godown and not the business. Until they are sold they are your inventory, and leaving them out understates the Balance Sheet by whatever happens to be out being processed on the closing date. Count them, and value them at what left with them.
What the stock is worth
Cost, not what you hope to sell it for — and where the market has fallen below cost, the lower of the two. Use weighted average or FIFO, and apply the same method every period. In processing, cost includes the processing: grey bought at ₹95 and finished at a mill charge of ₹25 stands at ₹120, not ₹95.
Once a period, not once a year
Strike the valuation at each period end and let one period's closing be the next one's opening. Then a month that bought heavily and a month that sold it each read correctly, instead of one showing a loss and the next a windfall.