Assume PartsPeople sold goods to a customer with terms FOB shipping on December 29, 2019. The company correctly recorded this as a sale on December 29, but due to a data-processing error, the goods, with what is form w a cost of $900, were not removed from inventory. Further, assume that a supplier sent a shipment to PartsPeople on December 29, also with the terms FOB shipping, and the cost of these goods was $500.
- This occurs because it will look like the company used more resources than it actually did relative to the level of sales recorded.
- Let’s walk through a numerical example to illustrate the impact of an understated ending inventory on a company’s financial statements.
- However, knowing more about ways that inventory can be understated can help you identify situations where you may need to look closer at your financial statements.
- It also has an indirect effect on owners’ equity through its impact on net income.
A periodic inventory method works on a system that calculates the cost of the goods sold (COGS). This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock. Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement.
Accounting for Inventory: The Impact of Inventory Discrepancies on Financial Reporting
As the ending inventory for one accounting period becomes the opening inventory for the next period, it is easy to see how an inventory error can affect two accounting periods. Let’s look at a few examples to determine the effects of different types of inventory errors. Understated inventory may be caused by inventory record keeping errors, as well as by an inadequate count of the ending inventory.
- When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues.
- This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period.
- Despite your best intentions, mistakes can be made while preparing company financial records.
- When running a business, the amount of inventory that you have on hand can have a drastic effect on the profitability of your company.
- This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock.
- When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated.
From the chart, working capital and the current ratio are understated because part of the ending inventory is missing (not included in the count). Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. John Freedman’s articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public company auditing and work with the campus recruiting team for his alma mater. In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount.
4: Impacts of Inventory Errors on Financial Statements
It can also be triggered by an incorrect extension of inventory unit counts to derive the final inventory valuation. Consequently, a business should use cycle counting to continually verify whether its inventory records match its physical inventory. It can also review inventory valuations on a trend line to see if there are any unusual spikes or dips in the valuation amounts over time, which may be worthy of further investigation.
AccountingTools
On the balance sheet, ending inventory is part of current assets and therefore has a direct (positive) relationship with them. If the ending inventory is understated, the total current assets will be understated, and vice versa. It does have an effect on owners’ equity, which is calculated as the net income of the period transferred to the owners’ equity account at the end of the period. If the ending inventory is understated, the owners’ equity will be understated, and vice versa.
These goods were not received until January 4 of the following year, but due to poor cut-off procedures at PartsPeople, these goods were not included in the year-end inventory balance. The net income for an accounting period will directly depend on the valuation of the ending inventory. Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count. It is necessary to compare the inventory counts recorded to actual quantities on the warehouse shelves and assess why differences have occurred before adjusting the data to reflect this analysis.
Example of Overstated Ending Inventory
Any of the four costing approaches in the periodic inventory method will produce a different result over the same accounting period. Therefore, it is necessary and often a legal requirement, for one method to be chosen and applied consistently across future reporting periods to maintain accuracy. When running a business, the amount of inventory that you have on hand can have a drastic effect on the profitability of your company. Because of the importance of inventory to a business, it is essential to know exactly how much you have on hand at all times. If the inventory is reported incorrectly, it can have drastic effects on your business.
The total cost of goods sold, gross profit, and net income for the two periods will be correct, but the allocation of these amounts between periods will be incorrect. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct. The chart below identifies the effect that an incorrect inventory balance has on the income statement. Proper inventory valuation is important when accounting for inventory through financial reporting. If inventory is not correctly valued inventory discrepancies will impact financial statements such as balance sheets, income statements and statements of retained earnings.
Ending income may be overstated deliberately, when management wants to report unusually high profits, possibly to meet investor expectations, meet a bonus target, or exceed a loan requirement. If ABC has a marginal income tax rate of 30%, this means that ABC must now pay an additional $150 ($500 extra income x 30% tax rate) in income taxes. These three illustrations are just a small sample of the many kinds of inventory errors that can occur. In evaluating the effect of inventory errors, it is important to have a clear understanding of the nature of the error and its impact on the cost of goods sold formula. Although immediate correction of errors is preferable, most inventory errors will correct themselves over a two-year period. However, even if an error corrects itself, there may still be a need to restate comparative financial-statement information.
In addition to writing informative articles, he published a book, “Modern Day Parables,” in 2008.
Accounting for inventory
A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, the cost of inventory sold is recorded as cost of goods sold. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings.
