6 4: Impacts of Inventory Errors on Financial Statements Business LibreTexts

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.

During a period of rising prices or inflationary pressures, FIFO (first in, first out) generates a higher ending inventory valuation than LIFO (last in, first out). Inventory may also need to be written down for various reasons including theft, market value decreases, and general obsolescence in addition to calculating ending inventory under typical business conditions. Inventory market value may decrease if there is a large dip in consumer demand for the product.

Example of the Effect of Understated Ending Inventory

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.

• Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity.
• 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.
• 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.
• 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.
• 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.

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. 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.

Financial Accounting

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. In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount. If the company shows too little of that cost as its ending inventory (say $15,000 instead of $25,000), it will mean that too much cost will appear on the 2022 income statement as the cost of goods sold ($225,000 instead of $215,000).

The result is reported profits that are $30,000 lower than is really the case. 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. 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.

Inventory Understatement Error:

First in, first out (FIFO) assumes that the oldest items purchased by the company were used in the production of the goods that were sold earliest. Under FIFO, the cost of the oldest items purchased are allocated first to COGS, while the cost of more recent purchases are allocated to ending inventory—which is still on hand at the end of the period. 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. In these cases, there are a variety of tools for fraudulent inventory overstatement, such as reducing any inventory loss reserves, overstating the value of inventory components, overcounting inventory items, overallocating overhead, and so forth. Understated inventory may be caused by inventory record keeping errors, as well as by an inadequate count of the ending inventory.

When the inventory asset is understated at the end of the year, then income for that year is also understated. 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. The next step is to assign one of the three valuation methods to the items in COGS and ending inventory. Let’s assume the 200 items in beginning inventory, as of 7/31, were all purchased previously for $20.

If inventory is understated at the end of the year, what is the effect on net income?

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. This means that 700 items were forming a corporation 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.

It can also be triggered by an incorrect extension of inventory unit counts to derive the final inventory valuation. 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.

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). This means that the cost of goods sold for 2023 will be too low by $10,000. 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). A new business buys $1 million of merchandise during a year, and records 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.

Auditors may require that companies verify the actual amount of inventory they have in stock. Doing a count of physical inventory at the end of an accounting period is also an advantage, as it helps companies determine what is actually on hand compared to what’s recorded by their computer systems. To go back to the preceding example, if ABC Company would otherwise have had a net profit before tax of $3,500, the overstatement of ending inventory of $500 now reduces the cost of goods https://online-accounting.net/ sold by $500, which increases ABC’s net profit before tax to $4,000. 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, income taxes must then be paid on the amount of the overstatement.

Importance of proper inventory valuation

Raw materials are those used in the primary production process or materials that are ready to be manufactured into completed goods. 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. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.