What happens if ending inventory is understated

This occurs because it will look like the company used more resources than it actually did relative to the level of sales recorded. If the cost of goods sold is overstated, that means that the overall expense will be too high as well. If expense is overstated, then net income will be understated. Lastly, this leads to an understatement of equity. 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.

Therefore, if ending inventory is understated in the current year, it will be overstated in the subsequent year. This means that cost of goods sold will be understated, total expense will be understated, net income will be overstated and equity will be overstated. 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. 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:. How would you respond to this request? Write a memo, detailing your willingness or not to embrace this suggestion, giving reasons behind your decision.

Remember to exercise diplomacy, even if you must dissent from the opinion of a supervisor. Note that the challenge of the assignment is to keep your integrity intact while also keeping your job, if possible.

Skip to content Inventory. Fundamentals of the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet Understanding this interaction between inventory assets merchandise inventory balances and inventory expense cost of goods sold highlights the impact of errors. Example 1.

Assume these values to be correct no inventory error. Key Concepts and Summary The value for cost of the goods available for sale is dependent on accurate beginning and ending inventory numbers. Because of the interrelationship between inventory values and cost of goods sold, when the inventory values are incorrect, the associated income statement and balance sheet accounts are also incorrect.

Inventory errors at the beginning of a reporting period affect only the income statement. 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.

Inventory errors at the end of a reporting period affect both the income statement and the balance sheet. Overstatements of ending inventory result in understated cost of goods sold, overstated net income, overstated assets, and overstated equity. Conversely, understatements of ending inventory result in overstated cost of goods sold, understated net income, understated assets, and understated equity.

Goods held on consignment are omitted from the physical count. Goods purchased and delivered, but not yet paid for, are included in the physical count. Purchased goods shipped FOB destination and not yet delivered are included in the physical count.