Why is the accuracy of inventory valuation so important?

Definition of Inventory Accuracy

Inventory accuracy means the following:

  • Accurate counts of the items in inventory
  • Proper cost of each item in inventory (based on the company's cost flow assumption)
  • Accurate tabulations
  • Proper cut-off of vendor invoices, receiving reports, etc.
  • Accounting for goods in transit, goods on consignment, etc.

The cost of each item in inventory is based on the actual costs of the items purchased or produced by the company in the current accounting period, plus the cost of the items contained in the beginning inventory.

Example of Importance of Accurate Inventory

Here is an example of why accuracy in calculating inventory is important. After accounting for the total cost of 1) the items purchased or produced in the current period, plus 2) the costs of items carried over from the previous period, must be divided up as follows:

Therefore, if too much of the total cost is assigned to the ending inventory, too little will be assigned to the cost of goods sold. And vice versa.

Further, the cost reported as inventory will affect the calculations of the company's working capital, total assets, and stockholders' or owner's equity.

The amount reported as the cost of goods sold will affect the calculations of gross profit and net income.

Since the amount reported as the cost of this year's ending inventory will carry forward to become the beginning inventory of the next year's inventory, any error will mean the income statements of both years will report incorrect amounts for the cost of goods sold, gross profit, and net income.

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