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Inventory is a line item on your balance sheet and cost of goods sold (COGS) to calculate net income on your income statement. If your inventory records have any errors, they can affect your financial statements and create an inaccurate financial picture. Let’s look at this in more detail, then we will talk about correcting financial errors on your financial statements. 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. For more information about conducting automotive parts inventory counts contact Pro Count West today. When ending inventory is overstated, this reduces the amount of inventory that would otherwise have been charged to the cost of goods sold during the period. The result is that the cost of goods sold expense declines in the current reporting period. You can see this with the following formula to derive the cost of goods sold: Beginning inventory + purchases - ending inventory = Cost of goods sold Example of Overstated Ending InventoryIf ABC Company has beginning inventory of $1,000, purchases of $5,000, and a correctly counted ending inventory of $2,000, then its cost of goods sold is as follows: $1,000 Beginning inventory + $5,000 Purchases - $2,000 Ending inventory = $4,000 Cost of goods sold But if the ending inventory is incorrectly stated too high, at $2,500, the calculation becomes: $1,000 Beginning inventory + $5,000 Purchases - $2,500 Ending inventory = $3,500 Cost of goods sold In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount. Impact of an Inventory CorrectionIf the ending inventory overstatement is corrected in a future period, this problem will reverse itself when the inventory figure is dropped, thereby shifting the overstatement back into the cost of goods sold, which increases the cost of goods sold in whichever future period the change occurs. Impact of an Inventory Overstatement on Income TaxesWhen 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. Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes. 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 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. Fraudulent Inventory OverstatementsEnding 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. What happens if the ending inventory is overstated?When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS. When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated.
What financial statements are affected by an error in the ending inventory?Errors in the valuation of ending merchandise inventory, which is on the balance sheet, produce an equivalent corresponding error in the company's cost of goods sold for the period, which is on the income statement. When cost of goods sold is overstated, inventory and net income are understated.
What is affected by ending inventory?This directly affects the gross profit reported on the income statement, which is calculated by subtracting COGS from net sales revenue. Ending inventory valuation therefore affects the amount of income tax the company needs to pay for the period.
What happens to profit when ending inventory is understated?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.
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Which of the following financial statement line items will be affected if the ending inventory is overstated?
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