Importance of proper inventory valuation

A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, the cost of inventory sold is recorded as cost of goods sold. Since the cost of goods sold figure affects the company’s net income, 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 a 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.

Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to inventory, matching 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 goods on hand and thus carried forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues.  Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:

• First, a merchandising company must be sure that it has properly valued its ending inventory. If the ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be overstated. Thus, any change in the calculation of ending inventory is reflected, dollar for dollar (ignoring any income tax effects), in net income, current assets, total assets, and retained earnings.
• Second, when a company misstates its ending inventory in the current year, the company carries forward that misstatement into the next year. This misstatement 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 washes out, and assets and retained earnings are properly stated.

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income are understated. Note, however, that when net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings. Exhibit 3 summarizes the effects of errors of inventory valuation:

Exhibit 3: Inventory errors