Impacts of Inventory Errors On Financial Statements

CFAS INVENTORIES
If the ending inventory is overstated, cost of goods sold is understated, resulting

in an overstatement of gross margin and net income. ... This misstatement occurs
because the ending inventory amount of the current year is the beginning
inventory amount for the next year
Impacts of Inventory Errors on Financial Statements

Importance of proper inventory valuation
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.
Recall that in each accounting period, the appropriate expenses must be matched with
the revenues of that period to determine the net income. Applied to inventory, matching
involves determining (1) how much of the cost of goods available for sale during the
period should be deducted from current revenues and (2) how much should be
allocated to goods on hand and thus carried forward as an asset (merchandise
inventory) in the balance sheet to be matched against future revenues. Net income for
an accounting period depends directly on the valuation of ending inventory. This
relationship involves three items:
 First, a merchandising company must be sure that it has properly valued its
ending inventory. If the ending inventory is overstated, cost of goods sold is
understated, resulting in an overstatement of gross margin and net income. Also,
overstatement of ending inventory causes current assets, total assets, and
retained earnings to be overstated. Thus, any change in the calculation of ending
inventory is reflected, dollar for dollar (ignoring any income tax effects), in net
income, current assets, total assets, and retained earnings.
 Second, when a company misstates its ending inventory in the current year, the
company carries forward that misstatement into the next year. This misstatement
occurs because the ending inventory amount of the current year is the beginning
inventory amount for the next year.
 Third, an error in one period’s ending inventory automatically causes an error in
net income in the opposite direction in the next period. After two years, however,
the error washes out, and assets and retained earnings are properly stated.
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:
Account Inventory Error
Cost of goods sold Overstated Understated
Net Income Understated Overstated
Ending Inventory Understated Overstated
What are the effects of overstating inventory?
If a corporation overstates its inventory, it will also be overstating its gross profit and net

income as well as its current assets, total assets, retained earnings, stockholders' equity, and all of
the related financial ratios.
The gross profit and net income are overstated as a result of overstating inventory because not
enough of the cost of goods available is being charged to the cost of goods sold. The higher
amount of net income means that the reported amount of retained earnings and stockholders'
equity is also too high.
Since the overstated amount of inventory at the end of one accounting period becomes the
beginning inventory of the following period, the following period's cost of goods sold will be too
high and will result in the period's gross profit and net income being too low. (The retained
earnings and other balance sheet amounts will be correct at the end of the second period.)
When cost of goods sold is overstated, inventory and net income are understated.
When cost of goods sold is understated, inventory and net income are overstated
An overstatement to ending inventory overstates net income, but next year, since
ending inventory becomes beginning inventory, it understates net income. So over a
two-year period, this corrects itself. However, financial statements are prepared for
one period, so all this means is that two years of cost of goods sold are misstated
(the first year is overstated/understated, and the second year is
understated/overstated.)

Impacts of Inventory Errors On Financial Statements

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CFAS INVENTORIES

If the ending inventory is overstated, cost of goods sold is understated, resulting

Impacts of Inventory Errors on Financial Statements

A merchandising company can prepare accurate income statements, statements of

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net

Account Inventory Error

Cost of goods sold Overstated Understated

Net Income Understated Overstated

Ending Inventory Understated Overstated

What are the effects of overstating inventory?

If a corporation overstates its inventory, it will also be overstating its gross profit and net

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