Significance of Inventory Valuation

Inventory is generally the largest of the current asses held by a trading or manufacturing enterprise. In some cases it may account for 75% or even more of the total current assets. It is widely recognized that the major asset that affect efficiently of operation is inventory. Both, excess of inventory and its shortage affects the productive activity and the profitability of the enterprise whether it is manufacturing trading or service business. Unwise investment in inventories in the first instance and its proper valuation later on also affects the liquidity of the firm and hampers the cash flow management. Thus the significance of inventory valuation arises fro more than one reason as explained in the subsequent paragraphs.

Effect on Income Liquidity:

Short term creditors are interested in the liquidity positions of the business enterprise and the general test for liquidity is the aggregated amount of current assets in relation to current liabilities. The proper valuation of inventories which constitution a major properties of current assets is essential so that this item of current asset is not overstated so as to misstate liquid position of the business.

Effect to income statement:

The proper determination of income depends on the proper valuation of all assets fixed and current. Since inventories are generally large and fluctuating in amount, the net income is influenced by the allocation of cost of fixed assets (i.e., depreciation accounting) and valuation method used in determining the ending inventory. Income is affected because an error in inventory valuation will affect the major elements of the income statement such as cost of goods sold, gross profit and ultimately the net income. The gross profit is directly affected by the stock valuation. The gross profit is the excess of sales revenues over the cost of goods sold. And if the ending inventory is overvalued, gross profit is overstated and an undervaluation of ending understates the gross profit earned. The reason is to be found in the following relationship:

Cost of Goods Sold = Opening Stock + Purchases – Closing Stock + Direct Expenses.

Thus higher the amount of ending inventory, the lower the cost of the goods sold and ice versa.  Cost of goods sold ultimately affects the gross profit. It is important to note that the ending inventory for one year is also the beginning inventory (or opening stock) of the next accounting period. Any error in ending inventory, therefore, produces an identical error in the opening inventory of the next accounting period. Therefore, the income statement of the second year will also be affected to the full extent of the inventory error made in year one. The resulting overstatement of beginning inventory, because ending inventory of last year was overstated, will result in an understatement of net income in that year. This counter balancing effect of an error in inventory valuation will result in a correct total net income for the two-year period. But it will definitely fail to produce correct income for the individual accounting periods respectively.

The effect of misstatement of inventory figure on the income is always through cost of goods sold and gross profit.

Effect on balance sheet:

As inventory is generally the largest of the current assets owned by a business entity, as error in a valuation of inventories may cause a misrepresentation of its financial position. The balance sheet will not give a true and fair view of the affairs of the business. An under-or-overstatement of stock will result in other mistake in the balance sheet such as  the total current assets, total assets, owner(s)’ equity and, the total of liabilities and owner(s)a equity.

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