This is very unlikely that a business sells all the goods that it purchased during the current period. Therefor cost of purchases is not directly subtracted from sales revenue in the trading section of income statement as some of the goods purchased remain to be sold which are known as closing inventory.
Normally businesses make no attempt to determine or record the purchase cost of goods sold at the time of sale. Moreover for recording transactions involving inventory movements, purchases, sales, return inwards and return outwards accounts are used.
In this case businesses determine the value of closing inventory only at the end of the period through physical counting. This entails that changes in inventory values (and the change in cost of sales) are not determined until the trading section of income statement is prepared at the end of the period.
The closing inventory is subtracted from purchases because it remains unsold, this closing inventory will become opening inventory for the next period.
If goods for resale are not sold by the year end (closing inventory) then the cost of these goods will be transferred to the period in which they are sold. This means that the cost of these goods is taken out of the profit calculation for the year in which they were purchased and will be used in the profit measurement for the year in which they were sold. In the meanwhile this closing inventory is shown as an asset and transferred to the following year as opening inventory.
Entry, Account Preparation and Example of Closing Inventory:
In the above account, entry on 1 January 2008 in inventory account represents opening inventory for January 2008.