Accounting for Inventory: The Impact of Inventory Discrepancies on Financial Reporting

Accounting for Inventory: The Impact of Inventory Discrepancies on Financial Reporting

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. Let’s walk through a numerical example to illustrate the impact of an understated ending inventory on a company’s financial statements.

The cost recorded of inventory on the company’s balance sheet is a function of the number of units recorded and the cost of the units. Whether the inventory understatement is caused by quantity or price issues, the effect on equity is the same — inventory understatement leads to equity understatement. The beginning inventory, or the inventory balance carried over from the previous period, also has an impact on the current period’s financial statements. On the income statement, beginning inventory is an addition in the calculation of the cost of goods sold, and therefore has a direct relationship with it.

  • Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count.
  • When the inventory asset is understated at the end of the year, then income for that year is also understated.
  • This, in turn, affects the gross profit, which is calculated as net sales minus the cost of goods sold.
  • This would involve adjusting the value of the ending inventory to the correct amount and making corresponding adjustments to COGS, gross profit, net income, and tax liabilities.
  • Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS.
  • So now that we know cost of goods sold is understated, you can see how that impacts the income statement in the visual below.

The company correctly recorded this as a sale on December 29, but due to a data-processing error, the goods, with 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. 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. So now that we know cost of goods sold is understated, you can see how that impacts the income statement in the visual below. When cost of goods sold is understated, gross profit is overstated, and net income is overstated (as well as retained earnings). Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count.

cost of goods sold will be understated and gross profit will be

The following charts and examples should help you with understanding how inventory errors impact the financial statements. 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. A new business buys $1 million of merchandise during a year, and records free competitive analysis templates ending inventory of $100,000, which results in a cost of goods sold of $900,000. However, the ending inventory was undercounted by $30,000, so the ending inventory balance should have been $130,000, which means that the cost of goods sold should have been $870,000. 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.

  • Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated.
  • 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.
  • An “understated ending inventory” in accounting refers to a situation where the value of the ending inventory is reported to be less than its actual value.
  • An understated inventory indicates there is less inventory on hand than the actual stock amount.
  • This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock.

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. 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.

Impacts of Inventory Errors on Financial Statements

The ending inventory, or the cost of merchandise on hand at the end of an accounting period, has an impact on the current period’s financial statements. On the income statement, ending inventory is a deduction in the calculation of the cost of goods sold, and therefore has an indirect (negative) relationship with it. If the ending inventory is understated, the cost of goods sold will be overstated, and vice versa. This, in turn, affects the gross profit, which is calculated as net sales minus the cost of goods sold. If the ending inventory is understated, the gross profit will be understated, and vice versa. Net income, which is calculated as gross profit minus operating expenses, is also affected by the ending inventory in the same way as gross profit.

Definition of Overstating Inventory

If the inventory is reported incorrectly, it can have drastic effects on your business. If both purchases and ending inventory are understated, net income for the period is not impacted because purchases and ending inventory are both understated by the same amount. In 2023, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000).

This can arise from errors in receipting stock, failure to reconcile the movement of raw materials and finished goods from one location to another and unrecorded transactions. Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS. The net income for an accounting period will directly depend on the valuation of the ending inventory. 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 the company discovers the mistake, it should issue correcting entries and potentially restate prior-period financial statements, depending on the significance of the error. This would involve adjusting the value of the ending inventory to the correct amount and making corresponding adjustments to COGS, gross profit, net income, and tax liabilities. Again, using our cost of goods sold formula, we can see that an understatement of purchases will result in an understatement of the cost of goods sold. As the ending inventory balance was counted correctly, one may think that this problem was isolated to this year only.

The reason is that, if costs are not included in inventory, then by default they must have been included in the cost of goods sold. When this happens, costs are transferred from the balance sheet to the income statement, so that some of the inventory asset is incorrectly charged to expense. After 2020, as noted above, the error would have corrected itself, so no adjustment would be required. 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. Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers.

Effect of Ending Inventory on Financial Statements

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. Assume PartsPeople sold goods to a customer with terms FOB shipping on December 29, 2019.

Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. When not writing about inventory management, you can find her eating her way through Auckland. Inventory discrepancies occur between the value of inventory captured in records and the value of the actual inventory held.

It is important for businesses to accurately track and value their inventories to ensure the accuracy of their financial statements. Using our previous company, assume PartsPeople missed counting a box of rotors during the year-end inventory count on December 31, 2019, because the box was hidden in a storage room. Further assume that the cost of these rotors was $7,000 and that the invoice for the purchase was correctly recorded. If we consider the cost of goods sold formula above, we can see that understating ending inventory would have overstated the cost of goods sold, as the ending inventory is subtracted in the formula.

Virgil
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