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. https://quick-bookkeeping.net/ The result is reported profits that are $30,000 lower than is really the case. Miscounting inventory doesn’t just have an effect in the period that the balance was miscounted. Because the ending inventory for one year is the beginning inventory in the next year, the next year will be misstated as well, but in the opposite direction.

  • Understating the amount of bad debt makes both the income statement and balance sheet look stronger and healthier.
  • Because the ending inventory for one year is the beginning inventory in the next year, the next year will be misstated as well, but in the opposite direction.
  • The dollar amount of ending inventory can be calculated using multiple valuation methods.
  • Whether the inventory understatement is caused by quantity or price issues, the effect on equity is the same — inventory understatement leads to equity understatement.
  • Luke Arthur has been writing professionally since 2004 on a number of different subjects.

John Freedman’s articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public https://business-accounting.net/ company auditing and work with the campus recruiting team for his alma mater. 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).

Error

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 end inventory is subtracted from this stock, to provide the total COGS.

Employee or customer theft can cause inventory to go missing, which is known as shrink. 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. Although the balance is correct and the accounting records will be accurate, shrink increases cost of goods sold, total expense and reduces profit and equity, as compared to what these balances could have been. Accordingly, you should work to identify opportunities to control shrink before you find the missing goods during the annual count.

Example of the Effect of Understated Ending Inventory

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. 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. Average weighted COGS is a simple way to value ending inventory, and best to use when all products sold are identical.

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The following charts and examples should help you with understanding how inventory errors impact the financial statements. After 2020, as noted above, the error would have corrected itself, so no adjustment https://kelleysbookkeeping.com/ would be required. However, the 2019 financial statements used for comparative purposes in future years would have to be restated to reflect the correct amounts of inventory and cost of goods sold.

Overstatement of Income

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. Last in, first out (LIFO) is one of three common methods of allocating cost to ending inventory and cost of goods sold (COGS).

Why track ending WIP inventory?

Let’s look at a few examples to determine the effects of different types of inventory errors. Most businesses use the first-in first-out (FIFO) method of allocating costs to inventory, which assumes the inventory stock that you purchased first is sold first. You can track changes to any beginning inventory by comparing this with the previous period. Increased beginning inventory could also be due to a business increasing stock before a busy holiday season – or it could signal a downward trend in sales. An understated inventory indicates there is less inventory on hand than the actual stock amount. 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.

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. An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS. 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. When running a business, the amount of inventory that you have on hand can have a drastic effect on the profitability of your company. Because of the importance of inventory to a business, it is essential to know exactly how much you have on hand at all times. If the inventory is reported incorrectly, it can have drastic effects on your business.