Importance of Proper Inventory Valuation

Inventory is an important current asset. Inventory is an important barometer of business activity. The number of inventories and the time required to sell the goods on hand are two indicators to be watched carefully.

During downturns in the economy, since the sale of existing inventory longer time requires, there is a clear possibility of an initial buildup of inventories.

On the other hand,

inventories generally decrease with an upturn in business activity. So an optimum balance must be maintained between the too small quantity of inventory and too much quantity of inventory.

A business concern with too little inventory might face problem to satisfy its customers and sales personnel. On the other hand, one with too much inventory will be burdened with unnecessary carrying costs.

Inventories influence both the balance sheet and the income statement.

In the balance sheet of merchandising companies, inventory is the most significant current asset.

Of course,

its amount and relative importance can vary, even for companies of same nature.

For example,

Rangs Ltd. reported an inventory of $70 million, representing 80% of total current assets.

For the same period, General Electronics Company reported $60 million of inventory, representing 60% of total current assets. In the income statement, inventory plays an important role in determining the results of operations for a particular period.

Also, gross profit is closely observed by management, owners and other interested parties.

Preparation of accurate income statement, statement of retained earnings and balance sheet of a merchandise company depends mostly on correct valuation of its inventory.

A company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold which is shown in the income statement.

The cost of goods sold figure affects the company’s net income and it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings.

Inventories appear on the balance sheet under the heading “Current Assets,” which reports current assets in descending order of liquidity.

Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.

Under periodic inventory procedure, the cost of goods sold figure is ascertained by adding the beginning inventory to the net cost of purchases and deducting the ending inventory.

In each accounting period, matching of proper expenses with revenues of that period is essential to determine net income.

Matching inventory involves determining

(1) how much of the cost of goods available for sale during the period should be deducted from current revenues and

(2) how much should be allocated to ending inventory and thus carried forward as an asset in the balance sheet to be matched against future revenues?

Because as the cost of goods sold is determined to deduct the ending inventory from the cost of goods available for sale.

There exists a relationship: Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:

First, a company must properly value its ending inventory. When the ending inventory is overstated, cost of goods sold is understated, resulting in overstated gross profit and net income.

Also,

overstatement of ending inventory causes current assets, total assets and retained earnings to be overstated.

Second, when a- company makes error in its ending inventory in the current year, the company carries forward that erroneous ending inventory in the next year. This wrong statement occurs because the ending inventory amount of the current year is the beginning inventory amount for the next year.

Third, an error in one period’s ending inventory automatically causes an error in net income in the opposite direction in the next period.

After two years, however, the error automatically goes away and assets and retained earnings are properly stated.

Categories of Inventory

Inventory classification depends on the nature of the firm whether it is a merchandising or manufacturing concern. The inventory of merchandise firm is called merchandise inventory.

A manufacturing firm also owns inventories, but some goods may not be ready for sale. As a result, inventory is usually classified into three categories: finished goods, work-in-progress and raw materials.

A businessman maintains accounts of merchandise stock to know how much merchandise is there for sale and how much has already been sold.

For maintaining merchandise inventory either perpetual inventory system or periodic inventory system is followed.