Chapter 8
Inventory Valuation
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When closing inventory is correctly valued at $9,000, a COGS value of $71,000 is produced. As a
result, the gross profit for the year is $29,000.The gross margin for the reporting period is 29,000
÷ 100,000 = 29%
What happens if we overstate closing inventory by $1,000? This is shown in Figure 8.9.
Gross profit for the year is $30,000. Gross margin is then 30,000 ÷ 100,000 = 30%
Inventory Calculation
Opening Inventory
5,000
Plus: Purchases
75,000
Cost of Goods Available for Sale
80,000
Less: Closing Inventory
10,000
Cost of Goods Sold
70,000
Income Statement Year 1
Sales
$100,000
Less: Cost of Goods Sold
70,000
Gross Profit
$30,000
FIGURE 8.9
As a result, COGS is understated by $1,000, gross profit is overstated by $1,000, and gross margin
is overstated by 1%. The same error while performing a physical account for a company that uses
the perpetual inventory system will lead to the same problem.
If this error is found and corrected before the end of the period, then a journal entry must be
recorded to correct the balances of inventory and COGS. In this example, the correct journal entry
is shown in Figure 8.10. If inventory was instead understated by $1,000, the journal entry would
debit inventory and credit cost of goods sold.
JOURNAL
Page 1
Date
2016
Account Title and Explanation
Debit Credit
Dec 31 Cost of Goods Sold
1,000
Inventory
1,000
Corrected overstated inventory
_______________
FIGURE 8.10
If the error is made after the financial reporting period is over, then an assessment of the materiality
of the error must be made.
If the error is considered material, then the company’s financial statements must be reissued with
the amended figures. It is obviously a scenario that companies want to avoid. Such a high profile
mistake can only cast doubt on how the company is being run. Nevertheless, if such material
errors are found, they must be reported—regardless of any negative impact they may have on the
company's reputation.
This is just a snapshot of what errors in valuing inventory can do to a company’s financial statements.
Both internal and external stakeholders are affected by inventory errors. Such errors can affect
business decision-making, tax reporting and adherence to accounting procedures.
