7 5 Inventory Errors Intermediate Financial Accounting 1

Inventory-related income statement items include the cost of goods sold, gross profit, and net income. Current assets, working capital, total assets, and equity come from the balance sheet. All of these items are important components of financial ratios used to assess the financial health and performance of a business. The ending inventory of the current period becomes the beginning inventory of the following period, and therefore has an impact on the following period’s financial statements. On the income statement, the beginning inventory has a direct effect on the cost of goods sold and an indirect (negative) effect on gross profit and net income.

  • After 2020, as noted above, the error would have corrected itself, so no adjustment would be required.
  • If the ending inventory is understated, the owners’ equity will be understated, and vice versa.
  • Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.
  • 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.
  • Inventory-related income statement items include the cost of goods sold, gross profit, and net income.

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 daily cash receipts journal 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.

This occurs because it will look like the company used more resources than it actually did relative to the level of sales recorded. If the cost of goods sold is overstated, that means that the overall expense will be too high as well. Despite your best intentions, mistakes can be made while preparing company financial records.

Inventory Errors and Financial Statements

Because the ending inventory for one year is the beginning inventory in the next year, the next year will be misstated as well, but in the opposite direction. Therefore, if ending inventory is understated in the current year, it will be overstated in the subsequent year. This means that cost of goods sold will be understated, total expense will be understated, net income will be overstated and equity will be overstated.

The second, called work-in-process, refers to materials that are in the process of being converted into final goods. These goods have gone through the production process and are ready to be sold to consumers.

Similarly, obsolescence may occur if a newer version of the same product is released while there are still items of the current version in inventory. This type of situation would be most common in the ever-changing technology industry. Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement. Inventory discrepancies occur between the value of inventory captured in records and the value of the actual inventory held. Raw materials are those used in the primary production process or materials that are ready to be manufactured into completed goods.

Let’s assume the 200 items in beginning inventory, as of 7/31, were all purchased previously for $20. The weighted average cost method assigns a cost to ending inventory and COGS based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. It “weights” the average because it takes into consideration the number of items purchased at each price point. In 2023, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000). If the net purchases during 2023 are $270,000, the cost of goods available will be $285,000 (instead of $295,000).

Definition of Inventory is Understated

Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes. Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS. The first step is to figure out how many items were included in COGS and how many are still in inventory at the end of August. ABC company had 200 items on 7/31, which is the ending inventory count for July as well as the beginning inventory count for August. As of 8/31, ABC Company completed another count and determined they now have 300 items in ending inventory.

Impact on Investment

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. An incorrect inventory balance causes the reported value of assets and owner’s equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period.

How Does Understated Ending Inventory Affect Equity?

This means that 700 items were sold in the month of August (200 beginning inventory + 800 new purchases ending inventory). Alternatively, ABC Company could have backed into the ending inventory figure rather than completing a count if they had known that 700 items were sold in the month of August. 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.

What Happens if Ending Inventory Is Overstated?

Once you’ve identified that you’ve made a mistake, it can be useful to know how that error affects the conclusions you’ve arrived at. A common error, understatement of inventory, is usually caused by counting inaccuracy during the company’s annual inventory count. 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.

At its most basic level, ending inventory can be calculated by adding new purchases to beginning inventory, then subtracting the cost of goods sold (COGS). Advancements in inventory management software, RFID systems, and other technologies leveraging connected devices and platforms can ease the inventory count challenge. 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. When an ending inventory overstatement occurs, the cost of goods sold is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement.

However, the 2019 financial statements used for comparative purposes in future years would have to be restated to reflect the correct amounts of inventory and cost of goods sold. 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. Miscounting inventory doesn’t just have an effect in the period that the balance was miscounted.

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