Question

Why is proper inventory valuation so important? Why does an understated ending inventory understate net income for the period by the same amount? Explain and provide examples.

Answer 1

Inventory valuation is so important because that can impact on 2 financial statement that is income summery and balance sheet.

Because reported amount of inventory will impact on cost of goods sold and gross profit and net profit and also current assets , Working capital. And shareholders equity.

Inventory understated the net profit with same amount because when ending inventory is understated the cost of goods sold increase due to that with same amount profit is decrease too.

Ex: opening inventory $200 and ending inventory $75 and sale $350 and purchase $150

Cost of goods sold = opening inventory + purchase - ending inventory

= $200+$150-$75

= $275

So gross profit (net profit) = sales-cost of goods sold

= $350 - $275

= $75

When ending inventory is understated by $25

Net profit = sales - cost of goods sold

= $350 - ($200+$150-$50)

= $50

Hence, profit is decrease by same amount with understated ending inventory

(Note it is assumed that no other indirect expenses in our example )