Objectives of Inventory ValuationInventory is the most significant component of the current assets held by a trading or manufacturing enterprise. Inventory is a major asset that affects the efficiency of operations. Both, excess and shortage of inventory affects the production and the profitability of an enterprise. The significance of inventory valuation arises due to the following reasons:
Determination of Income:
The valuation of inventory is necessary for determining the true income earned by a business during a particular period. To determine gross profit, cost of goods sold is matched with the revenue of accounting period.
Inventory valuation has a major effect on income determination. The effect of overstatement and understatement of inventory may be explained as follows:
- When closing stock is overstated, net income for the accounting period will be overstated
- When opening stock is overstated, net income for the accounting period will be understated
- When closing stock is understated, net income for the accounting period will be understated
- When opening stock is understated, net income for the accounting period will be overstated
Note: When closing stock is overstated in the previous year, it means the opening stock of the current year is overstated and hence income of the current year is understated and vice-versa.
Ascertainment of financial position
Inventories are classified as current assets. The value of inventories on the date of Balance Sheet determines the financial position of the business. In case the inventory is not properly valued, the Balance Sheet will not disclose the correct financial position. It also affects the analysis of financial statements.