Chapter 8
Inventory Valuation
235
The Impact of Inventory Errors
A company that requires debt financing may try to make its financial statements appear better
by overstating inventory, which understates COGS and causes gross profit to be overstated. If
inventory is overstated unintentionally, it can give management a false sense of confidence in the
company. This could lead to bad decisions about pricing, discounts, target market share, or other
aspects of business performance.The reverse would be true for understated numbers, which could
create unnecessary panic and desperation.
An inaccurate gross profit figure can also have consequences when it comes to paying taxes. A
higher gross profit leads to higher net income, which means that a company is paying more tax
than it should. On the other hand, understating inventory would overstate COGS, which causes
gross profit and net income to be understated. This means that the government would get less in
taxes from the company than it should.
Finally, a company could use its inflated financial figures to create a false impression of its
performance for external stakeholders, or on banks when trying to secure loans.This can represent
an ethical breach in violation of the accounting principle of disclosure.
The Lower of Cost and Net Realizable Value
Market conditions can fluctuate.With respect to inventory, this means that sometimes a company
sells its inventory for a lower price than what it was purchased for in the first place (the selling price
is lower than cost). This could be due to an advancement in technology or a change in industry
trends, rendering older products obsolete or outdated.
The accounting principle of conservatism asserts that, given a choice, the accounting alternative
that produces a lower value for assets must always be used.This prevents companies from providing
an overly optimistic statement of their finances.This is a trade-off with the accounting principle of
measurement which states that inventory should be recorded at the cost identified by the inventory
value method used.
When a company determines that inventory must be sold at a price below cost, this asset must be
recorded at its
net realizable value (NRV)
. Net realizable value is the price that a company can
realistically expect to sell the item for, less any costs incurred to make the item ready for sale, such
as repair costs.This method is known as the
lower of cost and net realizable value (LCNRV)
.
For example suppose that Elan's Camera Shop sells point-and-shoot cameras, more expensive
DSLR cameras and camera bags. Cost and net realizable value are shown in Figure 8.11.
