Effects of Incorrect Valuations

Effects of incorrect valuations

Effects of incorrect valuations

How does an incorrect valuation of inventory affect profit?

• Inventory valuation affects both the gross profit and the profit for the year

  • Both are affected in the same way and by the same amount

• The opening inventory value is debited to the income statement

  • The opening inventory is an expense that is matched to the current financial period’s revenue

  • It is added to the cost of sales for the current period

  • Therefore, opening inventory decreases the profit

• The closing inventory value is credited to the income statement

  • The closing inventory is an expense that is matched to the next financial period’s revenue

  • It is subtracted from the cost of sales for the current period

  • Therefore, closing inventory increases the profit

• The table below shows how incorrect inventory valuation affects the gross profit and the profit for the year

  • The effects depend on whether it is the opening or closing inventory

How does an incorrect valuation of inventory affect capital and asset valuation?

• Inventory valuation affects both the capital and the asset valuation

• At the end of a financial period, the closing inventory is stated on the statement of financial position under current assets

  • Therefore, the valuation of the closing inventory directly affects the asset valuation

• The opening inventory is not stated on the statement of financial position

  • Therefore, the valuation of the opening inventory has no effect on the asset valuation

• The valuation of the closing inventory also affects the capital value in the statement of financial position

  • It affects the profit for the year, which is recorded as an element of capital in the statement of financial position

• The valuation of the opening inventory has no affect on capital at the end of the current period

  • The profit for the previous period would have been understated or overstated

    • This would mean the capital at the end of the previous period was incorrect

  • The profit for the current period would be understated or overstated

    • This would normally affect the capital at the end of the current year

  • However, the effects cancel each other out so that the capital at the end of the current year is unaffected

• The table below shows how incorrect inventory valuation affects capital and asset valuation

  • The effects depend on whether it is the opening or closing inventory