If inventory is miscounted during the company’s annual inventory count, this could cause inventory to be understated. 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. Therefore, if ending inventory is understanding operating margin understated in the current year, it will be overstated in the subsequent year.

Conversely, understatements of beginning inventory result in understated cost of goods sold and overstated net 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. The chart below identifies the effect that an incorrect inventory balance has on the income statement. An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. Conversely, understatements of ending inventory result in overstated cost of goods sold, understated net income, understated assets, and understated equity. In other words, how would an understatement of ending inventory and purchases impact the current year financial statements?

This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock. It is entirely possible that the error will not be found for many months. In February, the beginning inventory is still the $150,000 that was the January ending inventory. ABC International has beginning inventory in January of $200,000 and purchases $400,000 of inventory during that month. It is also important to consider the effect of the error on subsequent years. When PartsPeople recorded the invoice in 2020, the purchases for that year would have been overstated, which means the cost of goods sold was also overstated.

If we consider the cost of goods sold formula above, we can see that understating ending inventory would have overstated the cost of goods sold, as the ending inventory is subtracted in the formula. Using our previous company, assume PartsPeople missed counting a box of rotors during the year-end inventory count on December 31, 2019, because the box was hidden in a storage room. The gross profit in 2026 was overstated by $10,000 ($70,000 instead of the true $60,000). For example, if ending inventory is overstated in Year 1, the beginning inventory in Year 2 will also be overstated.

If inventory is understated at the end of the year, it means that the amount of inventory being reported is less than the true or correct amount. Correcting these errors involves adjusting the ending inventory to its accurate value. In Year 2, the overstated beginning inventory leads to higher COGS, reducing net income. In Year 2, the beginning inventory would carry over the incorrect ending inventory from Year 1, leading to further implications for COGS calculations.

How to Prevent an Understated Ending Inventory

• In 2026, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000).
• Understanding these effects is crucial for accurate financial reporting and decision-making.
• If inventory is miscounted during the company’s annual inventory count, this could cause inventory to be understated.
• Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS.
• Suppose beginning inventory and purchases were recorded correctly, but ending inventory was incorrect.

However, even if an error corrects itself, there may still be a need to restate comparative financial-statement information. These three illustrations are just a small sample of the many kinds of inventory errors that can occur. The company correctly recorded this as a sale on December 29, but due to a data-processing error, the goods, with a cost of $900, were not removed from inventory. Again, the error corrected itself over two years, but the allocation of income between the two years was incorrect.

Unit 6: Financial Reporting for a Merchandising Enterprise

If inventory is not correctly valued inventory discrepancies will impact financial statements such as balance sheets, income statements and statements of retained earnings. A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. The following charts and examples should help you with understanding how inventory errors impact the financial statements. One error in calculating the ending inventory of 2025 caused the individual income statements of 2025 and 2026 to report incorrect gross profits and incorrect net incomes.

How many accounting periods does an inventory error affect?

This will result in an understatement of the cost of goods sold and thus an overstatement of net income. As the ending inventory balance was counted correctly, one may think that this problem was isolated to this year only. At the end of two years, the error would have corrected itself, and the total income reported for those two years would be correct. If net sales for 2025 were $300,000, the gross profit will be incorrectly reported as $75,000 ($300,000 – $225,000) instead of the true amount of $85,000 ($300,000 – $215,000).

Income Statement Impact Summary

A common error, understatement of inventory, is usually caused by counting inaccuracy during the company’s annual inventory count. The overstatement of inventory in year one caused cost of goods sold to be understated and income overstated in year one. This means there are constant fluctuations in net income caused by inventory errors. Please note that the two accounting periods impacted by an inventory error do not have to be consecutive periods. An inventory error affects two consecutive accounting periods, assuming that the error occurs in the first period and is corrected in the second period. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings.

• Comparing the two examples with and without the inventory error highlights the significant effect the error had on the net results reported on the balance sheet and income statements for the two years.
• The goods shipped by the supplier should have been included in inventory, resulting in an under- statement of year-end inventory.
• The following charts and examples should help you with understanding how inventory errors impact the financial statements.
• This occurs because it will look like the company used more resources than it actually did relative to the level of sales recorded.
• Let’s return to The Spy Who Loves You Company dataset to demonstrate the effects of an inventory error on the company’s balance sheet and income statement.

On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Although immediate correction of errors is preferable, most inventory errors will correct themselves over a two-year period. what does full cycle accounts payable mean 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. However, the allocation of income between the two years was incorrect, and the company’s balance sheet at December 31, 2019, would have been incorrect. If ending inventory is overstated, the cost of goods sold (COGS) is understated, leading to an overstatement of gross profit and net income.

Common Inventory Errors

These ensure transparency and allow users to understand the correction’s implications. ✦ Description of the nature of the error ✦ Restate comparatives and disclose nature of correction 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. 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.

If a company understates its count of ending inventory in year 1, which of the following statements is correct?

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. If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. 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. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity. Suppose items that a company owns was not recorded as a purchase and therefore are not counted in ending inventory. From the chart, working capital and the current ratio are understated because part of the ending inventory is missing (not included in the count).

Overstatements of beginning inventory result in overstated cost of goods sold and understated net income. However, knowing more about ways that inventory can be understated can help you identify situations where you may need to look closer at your financial statements. Overstatements of ending inventory result in understated cost of goods sold, overstated net income, overstated assets, and overstated equity. If so, the second accounting period impacted by an inventory error will be the month in which it is corrected – however far in the future that period may be.

With lower taxable income, the company may underpay income taxes for that period. When the inventory asset is understated at the end of the year, then income for that year is also understated. Ending Inventory being overstated means we have to much, and need to correct it. If the beginning inventory is overstated, then cost of goods available for sale and COGS also are overstated. Inventories appear on the balance sheet under the heading “Current Assets,” which reports current assets in a descending order of liquidity. Therefore, cost of goods sold for the current period is understated because goods available is understated.

If the error is never found, then there is an impact in only one accounting period. Net income for an accounting period depends directly on the valuation of ending inventory. On the income statement, the cost of inventory sold is recorded as cost of goods sold. To summarize, inventory errors happen because of the nature of the asset.

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. 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. If both purchases and ending inventory are understated, net income for the period is not impacted because purchases and ending inventory are both understated by the same amount. In evaluating the effect of inventory errors, it is important to have a clear understanding of the nature of the error and its impact on the cost of goods sold formula.

Further assume that the cost of these rotors was $7,000 and that the invoice for the purchase was correctly recorded. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. 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). After subtracting the 2026 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). In 2026, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000).