What causes understatement of ending inventory?
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Let’s look at this in more detail, then we will talk about correcting financial errors on your financial statements. Show Ensure your auto parts inventory is accurate and true with an annual parts inventory. Your cost of goods sold (COGS) is the value of the inventory you sold over a specific time period. This time of year, you are probably looking at your annual COGS. To calculate COGS, you want to add your opening inventory to purchases during the year and subtract closing inventory. If you use inventory management software, it should calculate this number for you on your income statement. If you overestimate your COGS, you’ll have lower net income (beginning inventory too high and/or ending inventory too low). Under current assets on your balance sheet, ending inventory will also be understated. If COGS is understated (beginning inventory too low and/or ending inventory too high), then your ending inventory on your balance sheet will be too high and current assets will be overstated. You’ll also have a higher net income. Inaccurately reported income will also affect the retained earnings listed on the balance sheet. In either instance, inaccurate inventory will give you misinformation about your company’s performance, which can result in poor decision making. It will also cause more problems if the errors aren’t resolved and carry over from one year to the next. So how do you correct the errors to ensure you are properly reporting your financial position? You will need to record a reverse journal entry in the period you discover the error. Here are some examples:
You overstated an inventory purchase – debit your cash account and credit your inventory account by the overstated amount. You understated an inventory purchase – debit inventory and credit cash for the understated amount.
Previous year’s inventory was understated (leading to the current year’s beginning inventory being understated) – debit inventory and credit retained earnings by the overstatement in the new year. Previous year’s ending inventory was overstated (leading to the current year’s beginning inventory being overstated) – debit retained earnings and credit inventory by the understatement in the new year. You must also restate the prior year’s income statement and balance sheet when you find an inventory error. Inventory balance was overstated – increase COGS on the income statement, which will decrease net income; decrease ending inventory and decrease retained earnings on the balance sheet. Inventory balance was understated – decrease COGS on the income statement, which will increase net income; also increase ending inventory and increase retained earnings on the balance sheet. And remember, always write disclosure notes in the journal entry and on the financial statements to explain the nature and impact of the error. This will ensure viewers of the financial statements know about the previous issues and corrections. \( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \) \( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)\(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\) \(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\)\(\newcommand{\AA}{\unicode[.8,0]{x212B}}\) Importance of proper inventory valuationA 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. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity. 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. Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to inventory, matching involves determining (1) how much of the cost of goods available for sale during the period should be deducted from current revenues and (2) how much should be allocated to goods on hand and thus carried forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues. Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:
Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income are understated. Note, however, that when net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings. Exhibit 3 summarizes the effects of errors of inventory valuation: AccountInventory ErrorCost of goods soldOverstatedUnderstatedNet IncomeUnderstatedOverstatedEnding InventoryUnderstatedOverstatedExhibit 3: Inventory errors A Open Assessments element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/llfinancialaccounting/?p=130 CC licensed content, Shared previously
6.4: Impacts of Inventory Errors on Financial Statements is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts. What does it mean when ending inventory is understated?If ending inventory is understated, that means that the cost of goods sold, which is an expense, is overstated. As a result, net income will be understated. Expenses reduce net income so if too many expenses were recorded then this would cause net income to be understated.
What is the effect of understatement of closing stock on?Hence if the closing stock is under stated, this will results lower net income in that period.
What is the effect if an inventory account is understated at year end?This happens because the ending inventory balance is determined by deducting the cost of goods sold from cost from cost goods available for sale. Thus, if the inventory account is understated then the cost of goods sold automatically becomes overstated.
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