The Cost of Sales Adjustment (COSA)

The cost of sales adjustment refers to the difference between the current cost of inventories at the date of sale and the amount charged as the cost of goods sold in computing the historical cost profit. As we shall see in Part 5, business enterprises use standard costing systems for the purpose of obtaining timely information about the cost of inventories. These standard costing systems are designed to identify and to reflect, inter alia, changes in the current cost of purchased inventories. Where a standard costing system is in use, it is possible to derive an analysis of the variances which are differences between historical and standard costs, and to use this analysis to identify the extent to which current costs differ from standard costs. This information may be used to adjust the standard cost of goods sold to their current costs.

Where standard costing systems are not used, it is possible to average out the changes in the cost of sales. This method involves valuing the opening and closing inventories at the average cost for the year. The cost of sales is established as the purchases of the year, which are already stated at their average price for the year, adjusted by the revised values of the opening and closing inventories.

The purpose of this adjustment is to apply the concept of current value to monetary assets, to achieve the same effect as do the depreciation and the cost of sales adjustments in respect of fixed assets and inventories. Monetary working capital consists of trade debtors plus inventory not subjected to the cost of sales adjustment less trade creditors. Provided that it can be shown that it would be misleading to exclude them from monetary working capital, part of the bank balances and bank overdrafts, where applicable, may also be included in monetary working capital.

The objective of the monetary working capital adjustment and the cost of sales adjustments is to take account of the effects of changing prices on the financing requirements necessary to maintain the working capital applied to the day-to-day operations of the business. The relationship between the MWCA made in respect of trade debtors and trade creditors and the COSA is as follows:

(a) when sales are made on credit the business has to finance the changes in its input prices until the sales result in a receipt of cash. The part of the MWCA related to trade debtors, in effect, extends the COSA to allow for this; and

(b) conversely, when materials and services are purchased from suppliers who offer trade credit, price changes are financed by the supplier during the credit period. To this extent extra funds do not have to be found by the business and this reduces the need for a COSA and in some cases for a MWCA on debtors. The part of the MWCA related to trade creditors reflects this reduction.

SSAP 16 points out that there can be difficulties in practice in identifying, on an objective basis, those monetary assets and liabilities which are part of the net operating assets of the business. Nevertheless, a practical way of doing this has to be accepted if the operating profit is to be identified. Reasonable accuracy and objectivity may usually be achieved by including only trade debtors and trade creditors within monetary working capital, with an extension in the case of financial institutions. However, fluctuations in the volume of stock, debtors and creditors may lead to contrary fluctuations in cash or overdraft. It is necessary to include this element of cash or overdraft within monetary working capital if to do so has a material effect on current cost operating profit. Monetary working capital may also include cash floats required to support the business operations. The treatment adopted should be applied consistently.

Evidently, the method used to compute the monetary working capital adjustment should be compatible with that used to compute the cost of sales adjustment. For example, the sales of finished goods give rise to trade debtors. Hence, all things being equal, changes in the amount of finance required to support the increased level of trade debtors associated with price inflation will tend to be proportional to changes in the cost of goods finished. Consequently, the change in the index of finished goods prices is used to calculate that part of the monetary working capital which relates to supporting trade debtors. Equally, since the purchase of raw materials in the case of a manufacturing company gives rise to trade creditors, the change in the index of raw material prices is used to calculate that part of the monetary working capital which relates to trade creditors.

It should be noted that most of the problems associated with the calculation of the monetary working capital adjustment arise from the needs to identify monetary assets and liabilities associated with the net borrowing requirement. This net borrowing requirement affects the gearing adjustment which has to be made under current cost accounting.

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Read on: Main Features of Current Cost Accounting

SSAP 16 adopts the precise definition of large companies used in the EEC

Fourth Directive which reduces the number of companies subject to its application. According to SSAP 16 the basic objective of current cost accounting is to provide more useful information than that available from historical cost accounting alone, for the guidance of the management of the business, the shareholders and others on such matters as the financial viability of the business, return on investment, pricing policy, cost control and distribution decisions, and gearing.

Current cost accounting is described... see: Main Features of Current Cost Accounting