Inventory is an essential component of every business organisation and one of the key areas to be managed by an organisation is Inventory valuation. The inventory valuation includes all the costs incurred to get the inventory items in place and ready for sale. The inventory valuation excludes the costs of selling and administration. Inventory valuation allows a company to provide monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business and proper valuation of the inventories is necessary to ensure accurate financial statements. If inventory is not properly valued, expenses and revenues cannot be properly matched and the company may end up making poor decisions.
Inventory valuation is very important as it affects the cost of goods sold reported on the company’s income statement. The amount of inventory a company has in stock at the end of its financial year is called as Closing Inventory. It is closely related with ending inventory cost, which is the amount of money spent to get these goods into the business. The closing inventory of current year becomes the opening inventory for the next year.
Closing inventory appears in the Income Statement as well as the Balance Sheet and hence if it is not properly valued both the financial statements will provide inaccurate results. If the ending inventory is overstated then the Gross Profit and Net Income both will be overstated because the cost of goods sold during the period is stated too low. Since the ending inventory of one period becomes the opening inventory of the next period it will lead to inaccurate results in the next period.
Inventory being the largest current asset should be managed accurately. The method of inventory valuation that you choose can have significant effects on profitabilityand strategic planning. Therefore, it is very important to analyse inventory and make the right valuation from the beginning of the accounting period.