As soon as an account is opened for the purpose of recording a flow of value it is necessary to describe the source of the flow and its destination. We know that the purchases account is not the source of the flow of inventories to the inventory account, because we have deliberately refused to adjust the purchases account. We know also that, but for the need to measure income, we would not value inventories at the end of the year. Hence, by a fiction, the accountant states that the inventory adjustment comes from the income statement which is employed to measure income. The full accounting entries are, therefore, as follows:
Income statement for the year ended 31 December 19X0
31 Dec. Inventory 3,000
Inventory account 19X0 £
31 Dec. Income statement 3000
The effect of these entries is to solve the problem of income measurement, because the credit flow from the income statement is taken into the calculation of income, as follows:
Purchases 31,000 Sales 70,000
Closing inventories 3,000
The debit balance on the inventory account represents an asset which is carried over to the next year's income statement. The inventory account is an interesting account because it exists only to measure income, and since that is done on the last day of the accounting year, the inventory account only exists for one day. In fact, the closing inventory on the last day of the year is the opening inventory on the first day of the next accounting year. Hence, on the first day of the next accounting period, the inventory must be posted to the income statement of the next period, as follows:
Income statement for the year ended 31 December 19X1
1 Jan. Inventory 3,000
Inventory account 19X0 £ 19X1 £
The reader will now observe that the inventory account has served its purpose and may be closed. This is done by drawing a double line beneath the entries.
In practice, the accountant will not reverse the inventory into the income statement of the year 19X1, until 31 December 19X1 when he prepares that account. As a result, the trial balance for the year ended 31 December 19X1 will include a debit balance in respect of the inventory account in the amount of £3000. As the trial balance is always extracted before the inventory adjustment is made, the opening inventory always appears on the trial balance but the closing inventory is never shown.
The matching of revenues and expenses
The purpose underlying the accountant's effort to identify and correctly measure the revenues and expenses of an accounting period is to attempt to match them so as to obtain a measure of the 'financial effort' of earning the revenues of that period. The accountant's concern is always with financial efficiency which he equates with income. The matching of expenses and revenues is far more complicated than appears at first sight. So far, we have assumed that by correctly measuring the revenues and expenses attributable to the accounting year they have... see: The Matching of Revenues and Expenses