Explain why proper inventory valuation is so important to the calculation of a company's "bottom line" net income.
A merchandise company must be sure it has properly valued it inventory for three reasons. If the ending inventory is overstated, cost of goods are unstated which leads to an overstatement of the gross margin and net income. Overstating the ending inventories also affect the current assets, total assets and retained earnings because any changes to the ending inventory is calculated dollar for dollar (ignoring any, income tax effects), in net income, current assets and retained earnings.
Secondly, when a company misstates its ending inventory in the current year, the company carries the misstatement forward to the next year; the reason for this is the ending inventory for the current year is the beginning inventory for the next year.
Finally, an error in one accounting period ending inventory, automatically causes an error in the net income in the opposite direction in the next period. After 2 years, however the error washes out and the assets and retained earnings are properly stated.
What is the meaning of taking a physical inventory and why is it important to take a physical inventory when using a perpetual inventory system.
A physical inventory means a company must take a count, weigh, measure or estimate the physical quantities of the goods on hand. The use of this ensures companies are accurately stating the quantity of on hand inventory. When companies utilize a perpetual inventory system there are able to obtain real time data regarding cost of goods sold and ending inventory, which makes calculating net income easier.
Events can cause the Inventory account balance to differ from th...
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Inventories: Measurement. (2014, January 1). What is Included in Inventory?. Retrieved May 8, 2014, from http://connect.mcgraw-hill.com/sites/0077328787/student_view0/ebook/chapter8/chbody1/what_is_included_in_inventory_.htm
Hermanson, R., Edwards, J., & Maher, M. (2010).Accounting principles: A business perspective. (Vol. 2). Textbook Equity inc. DOI: www.textbookequity.com
Principles of Accounting. (2013, January 1). Principles of Accounting. Retrieved May 8, 2014, from http://www.principlesofaccounting.com/chapter8/chapter8.html
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