It is important to understand the reason for the need to have correct valuation of stock.
Simply, any incorrect stock valuation will have direct impact on the gross margin of an enterprise leading right down to the bottom-line which is the net income/profit of an enterprise.
As the closing stock is in the current asset of the balance sheet, any overstatement or understatement will again overvalue the overall assets of the balance sheet.
Based on the accounting equation concept ( Assets= Liabilities + Equity), this overvaluation of the stocks will lead to increase in owners’ equity.
Let’s look at the below illustration where the closing stock is overvalued from $1,000 to $3,000.
| OVER-STATE Stock Valuation |
CORRECT Stock Valuation |
Difference/ Impact |
|
| Revenues |
10,000 |
10,000 |
|
| Cost of Goods Sold: |
|||
| Purchases |
5,000 |
5,000 |
|
| Less :Closing Stock |
3,000 |
1,000 |
Wrong/Over-valuation of Stock by $2,000 |
| Cost of Goods Sold: |
2,000 |
4,000 |
|
| Gross Profit Margin |
8,000 |
6,000 |
2,000(Increase) |
| Less: Overheads |
5,000 |
5,000 |
|
| Net Income/Profit |
3,000 |
1,000 |
2,000(Increase) |
| Capital , End of Period |
2,000(Increase) |
||
| Stock, End of Period |
3,000 |
1,000 |
2,000(Increase) |