Effects of Incorrect Valuations (Cambridge (CIE) O Level Accounting)
Revision Note
Written by: Dan Finlay
Reviewed by: Lucy Kirkham
Effects of Incorrect Valuations
How does an incorrect valuation of inventory affect profit?
Inventory valuation affects both the gross profit and the profit for the year
Both are affected in the same way and by the same amount
The opening inventory value is debited to the income statement
The opening inventory is an expense that is matched to the current financial period’s revenue
It is added to the cost of sales for the current period
Therefore, opening inventory decreases the profit
The closing inventory value is credited to the income statement
The closing inventory is an expense that is matched to the next financial period’s revenue
It is subtracted from the cost of sales for the current period
Therefore, closing inventory increases the profit
The table below shows how incorrect inventory valuation affects the gross profit and the profit for the year
The effects depend on whether it is the opening or closing inventory
Effects if inventory is undervalued | Effects if inventory is overvalued | |
Opening inventory | Gross profit and profit for the year are overstated | Gross profit and profit for the year are understated |
Closing inventory | Gross profit and profit for the year are understated | Gross profit and profit for the year are overstated |
How does an incorrect valuation of inventory affect capital and asset valuation?
Inventory valuation affects both the capital and the asset valuation
At the end of a financial period, the closing inventory is stated on the statement of financial position under current assets
Therefore, the valuation of the closing inventory directly affects the asset valuation
The opening inventory is not stated on the statement of financial position
Therefore, the valuation of the opening inventory has no effect on the asset valuation
The valuation of the closing inventory also affects the capital value in the statement of financial position
It affects the profit for the year, which is recorded as an element of capital in the statement of financial position
The valuation of the opening inventory has no affect on capital at the end of the current period
The profit for the previous period would have been understated or overstated
This would mean the capital at the end of the previous period was incorrect
The profit for the current period would be understated or overstated
This would normally affect the capital at the end of the current year
However, the effects cancel each other out so that the capital at the end of the current year is unaffected
The table below shows how incorrect inventory valuation affects capital and asset valuation
The effects depend on whether it is the opening or closing inventory
Effects if inventory is undervalued | Effects if inventory is overvalued | |
Opening inventory | No effect on the assets No effect on capital | No effect on the assets No effect on capital |
Closing inventory | Assets are understated Capital is understated | Assets are overstated Capital is overstated |
Worked Example
Qays ends his financial year at 31 March each year.
On 31 March 2023, Qays incorrectly values his inventory at its net realisable value. For each item, the net realisable value is higher than the cost price.
Which of the following is not true?
A | The gross profit for the year ended March 2023 was understated. |
B | The profit for the year ended March 2024 was understated. |
C | The total assets at 31 March 2024 was not affected. |
D | The capital at 31 March 2023 was overstated. |
Answer
The inventory should be valued at the lower of cost and net realisable value. Therefore the inventory has been overstated.
Qays' value is used for the closing inventory for the year ended 31 March 2023, therefore for that year:
The gross profit and the profit for the year have been overstated
The total assets have been overstated
The capital has been overstated
Qays' value is used for the opening inventory for the year ended 31 March 2024, therefore for that year:
The gross profit and the profit for the year have been understated
The total assets and capital are not affected
Therefore, the correct answer is A.
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