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When preparing the consolidated statement of profit and loss why we add back the unrealized profit in the cost of sales?
Cost of sales represent the direct costs attributable to the production of the goods or supply of services by an entity.So even if the company make no real external sale that affects the cost of sales figure but what is the rationale behind adding the unrealized profit to cost of sales?Somewhere in the group there is inventory that has been valued at an over-valuation – it’s been valued at cost to the buying entity and that figure includes the profit element recognised by the selling entity
So group inventory is over-valued and needs to be reduced by the pup
Now, consider the effect of reducing the value of inventory. That reduction affects both the Statement of Financial Position (because the group current assets figure will be reduced) That results in the total of the assets’ side of that Statement being reduced
Now consider the effect on the calculation of cost of sales and you can consider it in either of 2 different ways:
1) because the total of the assets’ side of the Statement of Financial Position has been reduced, now we must also reduce the total of the equity + liabilities’ side of that Statement of Financial Position. So deduct the pup from the figure for retained earnings
2) the calculation for cost of sales (if you can remember your F3 studies) is:
Opening inventory +
Purchases –
Closing inventory
And if you reduce the value of that closing inventory by the value of the pup you’ll see that the cost of sales figure increases and that, in turn, reduces the reported profit
Is that any better?
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