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How to determine the overvaluation/undervaluation of the inventory?

Sridip Kumar Shaw (Executive-Accounts) (62 Points)

02 November 2016

How to determine the Overvaluation/Undervaluation of the Inventory? How these cases are to be accounted for and what are the impacts in Trial Balance & Final Accounts? Please explain in detail.

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SUPRIYA (PRACTICE) (853 Points)
Replied 02 November 2016

Generally every company / business follows Inventory valuation policy of cost or market price whichever is less.

However in some situations for example where it is impossible to derive cost of product produced or in case of retail sale there can be another method followed which must be according to Inventory valuation standard and acceptable laws.

So to derive whether inventory is overvalued/ undervalued or not you need to find out following:

1. The Inventory valuation policy which is consistently followed.

2. Whether the policy followed is acceptable as per laws and standard.

3. If Yes then check whether the rates of inventory are taken as per the policy or not.

For eg just take policy is cost or market value whichever is lower. Now derive the cost per unit produced and what were the market prices on the date of valuation. Compare and find the lowest and see if your inventory is valued correctly or not.

If your valuation is made at price higher then it is overvalued and vice versa.

Overvaluation of closing inventory means inflated/ increased profit while under-valuation means understated profits. Similarly overvalued opening inventory means understated profit and and undervalued opening inventory means high profit.

when you are following your policy of valuation of inventory consistently then the profit is not affected as same valuation method is used for valuing both opening as well as closing inventory.

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