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What happens if inventory is understated?

Conversely, in understated inventory, an adjustment entry needs to be made to remove the surplus stock, which in turn reduces closing stock to the correct level and increases the COGS. In each accounting period, any applicable expenses must correspond with revenue earnt to determine the business’ net income. When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues.

  • On the income statement, the cost of inventory sold is recorded as cost of goods sold.
  • Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count.
  • Inventory market value may decrease if there is a large dip in consumer demand for the product.
  • Current assets, working capital, total assets, and equity come from the balance sheet.
  • The inventory valuation method chosen by management impacts many popular financial statement metrics.

An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. 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.

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If an account or a figure on an account is overstated, the amount that is reported on the financial statement is more than it should be. Auditors will be asking the company’s directors to explain why non-current assets in the accounts were overstated and not reported how to compute direct materials variances at their recoverable amount. Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers. This discrepancy can be caused by theft, damage, fraud or incorrect inventory counts and administrative errors.

Last in, first out (LIFO) is one of three common methods of allocating cost to ending inventory and cost of goods sold (COGS). It assumes that the most recent items purchased by the company were used in the production of the goods that were sold earliest in the accounting period. Under LIFO, the cost of the most recent items purchased are allocated first to COGS, while the cost of older purchases are allocated to ending inventory—which is still on hand at the end of the period.

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.

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. 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. 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.

The effect of overstated ending inventory

Ending inventory is the value of goods still available for sale and held by a company at the end of an accounting period. The dollar amount of ending inventory can be calculated using multiple valuation methods. Although the physical number of units in ending inventory is the same under any method, the dollar value of ending inventory is affected by the inventory valuation method chosen by management.

The effect of understated ending inventory

Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes. Overstatements of beginning inventory result in overstated cost of goods sold and understated net income. Conversely, understatements of beginning inventory result in understated cost of goods sold and overstated net income. An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS.

4: Impacts of Inventory Errors on Financial Statements

If the differences are found and corrected during the company’s annual inventory count at the end of the year, then inventory will be properly stated on an accounting basis. Even though it may seem like this should be considered an understatement of inventory, the equity balance will be correct. Accordingly, you should work to identify opportunities to control shrink before you find the missing goods during the annual count. 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.

The inventory valuation method chosen by management impacts many popular financial statement metrics. 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. Despite your best intentions, mistakes can be made while preparing company financial records.

If the net purchases during 2023 are $270,000, the cost of goods available will be $285,000 (instead of $295,000). After subtracting the 2023 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). If net sales are $325,000, the gross profit will be $70,000 ($325,000 – $255,000) instead of $60,000 ($325,000 – $265,000). 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. The next step is to assign one of the three valuation methods to the items in COGS and ending inventory.

If ending inventory is overstated, then cost of goods sold would be understated. As you can see in the visual below, the incorrectly stated inventory balance is $25 higher than the correct ending inventory balance. Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of goods sold. Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated. 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.

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