Effect of Ending Inventory on Financial Statements

Effect of Ending Inventory on Financial Statements

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 also has an indirect effect on owners’ equity through its impact on net income.
  • 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.
  • On the balance sheet, ending inventory is part of current assets and therefore has a direct (positive) relationship with them.
  • 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.

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. 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. This understatement can arise from various reasons such as errors in counting, valuation mistakes, or even fraudulent activities aimed at manipulating financial statements. Variations in COGS will have a direct impact on a company’s income statements because the COGS is subtracted from sales to get the gross profit. An overstated inventory will inflate gross profits and conversely understating inventory will have a negative impact on gross profits. If ending inventory is overstated, then cost of goods sold would be understated.

Example of the Effect of Understated Ending Inventory

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 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).

Overstatement Effects of Ending Inventory

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 wave life sciences ltd 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.

Reconciling inventory discrepancies

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 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. An understated inventory balance can also be caused by incorrect costing information.

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.

Luke Arthur has been writing professionally since 2004 on a number of different subjects. In addition to writing informative articles, he published a book, “Modern Day Parables,” in 2008.

Importance of proper inventory valuation

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.

Mark
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