Ending inventory is the amount of goods that a company has in stock at the end of an accounting period. It is an important component of the cost of goods sold calculation, which determines the gross profit and net income of a business. However, ending inventory may not always be accurate due to various types of errors, such as incorrect counting, wrong unit of measure, improper cutoff, or system glitches. These errors can have significant impacts on the financial statements of a company, affecting not only the current period but also the subsequent period.
Contents
- 1 How ending inventory errors affect cost of goods sold and gross profit
- 2 How ending inventory errors affect net income and retained earnings
- 3 How ending inventory errors affect balance sheet accounts
- 4 Which financial statement item is not affected by an error related to ending inventory?
- 5 Conclusion
How ending inventory errors affect cost of goods sold and gross profit
The cost of goods sold (COGS) is the total cost of acquiring and producing the goods that a company sells during a period. It is calculated by subtracting the ending inventory from the sum of the beginning inventory and the purchases during the period. The gross profit is the difference between the sales revenue and the COGS. Therefore, any error in ending inventory will affect both the COGS and the gross profit in the opposite direction.
For example, suppose a company has a beginning inventory of $10,000, purchases of $50,000, sales revenue of $80,000, and an actual ending inventory of $15,000. The correct COGS and gross profit are:
- COGS = ($10,000 + $50,000) – $15,000 = $45,000
- Gross profit = $80,000 – $45,000 = $35,000
However, if the company overstates its ending inventory by $5,000 due to an error, then its COGS and gross profit will be:
- COGS = ($10,000 + $50,000) – $20,000 = $40,000
- Gross profit = $80,000 – $40,000 = $40,000
As you can see, overstating ending inventory leads to understating COGS and overstating gross profit. Conversely, understating ending inventory leads to overstating COGS and understating gross profit.
How ending inventory errors affect net income and retained earnings
The net income (or net loss) is the difference between the gross profit and the operating expenses. The retained earnings are the accumulated net income (or net loss) that a company has retained after paying dividends to its shareholders. Therefore, any error in ending inventory that affects gross profit will also affect net income and retained earnings in the same direction.
For example, suppose the company in the previous example has operating expenses of $25,000 and pays no dividends. The correct net income and retained earnings are:
- Net income = $35,000 – $25,000 = $10,000
- Retained earnings = $10,000
However, if the company overstates its ending inventory by $5,000 due to an error, then its net income and retained earnings will be:
- Net income = $40,000 – $25,000 = $15,000
- Retained earnings = $15,000
As you can see, overstating ending inventory leads to overstating net income and retained earnings. Conversely, understating ending inventory leads to understating net income and retained earnings.
How ending inventory errors affect balance sheet accounts
The balance sheet is a snapshot of a company’s assets, liabilities, and equity at a specific point in time. The ending inventory is reported as part of the current assets on the balance sheet. The retained earnings are reported as part of the equity on the balance sheet. Therefore, any error in ending inventory that affects retained earnings will also affect these two balance sheet accounts in the same direction.
For example, suppose the company in the previous example has total assets of $100,000 (including ending inventory), total liabilities of $50,000 (excluding dividends payable), and total equity of $50,000 (including retained earnings) at the end of the period. The correct balance sheet accounts are:
- Current assets (including ending inventory) = $100,000
- Total liabilities = $50,000
- Equity (including retained earnings) = $50,000
However, if the company overstates its ending inventory by $5,000 due to an error, then its balance sheet accounts will be:
- Current assets (including ending inventory) = $105,000
- Total liabilities = $50,000
- Equity (including retained earnings) = $55,000
As you can see, overstating ending inventory leads to overstating current assets and equity. Conversely, understating ending inventory leads to understating current assets and equity.
Based on the above analysis, we can conclude that sales revenue is not affected by an error related to ending inventory. Sales revenue is the amount of money that a company receives from selling its goods or services during a period. It is determined by the quantity and price of the goods or services sold, not by the inventory level at the end of the period. Therefore, sales revenue is independent of ending inventory and remains unchanged regardless of any error in ending inventory.
Conclusion
Ending inventory errors can have significant impacts on the financial statements of a company, affecting the COGS, gross profit, net income, retained earnings, current assets, and equity in the opposite direction of the error. However, sales revenue is not affected by an error related to ending inventory, as it is determined by the quantity and price of the goods or services sold, not by the inventory level at the end of the period.
According to AccountingTools, if an inventory error has resulted in an increase in the recorded amount of ending inventory, this means that the cost of goods sold is understated, so that profits are overstated. According to Business LibreTexts, an error in ending inventory carries into the next period, since ending inventory of one period becomes the beginning inventory of the next period, causing both the balance sheet and the income statement values to be wrong in year two as well as in the year of the error. According to Tyonote, when the ending inventory overstated it is overstated the profit and when ending inventory understated it is understated the profit.
