How to Correct Inventory Errors On Your Dealerships Financial Statement

Inventory is a line item on your balance sheet and cost of goods sold (COGS) to calculate net income on your income statement. If your inventory records have any errors, they can affect your financial statements and create an inaccurate financial picture. Inventory balance was understated – decrease COGS on the income statement, which will increase net income; also increase ending inventory and increase retained earnings on the balance sheet. Inventory balance was overstated – increase COGS on the income statement, which will decrease net income; decrease ending inventory and decrease retained earnings on the balance sheet. If ending inventory is overstated, then cost of goods sold would be understated.

  • In the business world, inventory plays a vital role in success and can impact financial statements.
  • Under current assets on your balance sheet, ending inventory will also be understated.
  • Both perpetual and periodic inventory systems also face potential errors relating to losses in value due to shrinkage, theft, or obsolescence.
  • Inventory balance was understated – decrease COGS on the income statement, which will increase net income; also increase ending inventory and increase retained earnings on the balance sheet.
  • This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period.

As you can see in the visual below, the incorrectly stated inventory balance is $25 higher than the correct ending inventory balance. Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of good sold. Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated. It is now December 31, 2018, and the current replacement cost of the ending merchandise inventory is $24,000 below the business’s cost of the goods, which was $97,000.

Business Operations

The chart below identifies the effect that an incorrect inventory balance has on the income statement. An incorrect inventory balance causes the reported value of assets and owner’s equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period. Over https://kelleysbookkeeping.com/what-goes-on-income-statements-balance-sheets-and/ a two-year period, misstatements of ending inventory will balance themselves out. For example, an overstatement to ending inventory overstates net income, but next year, since ending inventory becomes beginning inventory, it understates net income. This is an example of counterbalancing errors, or errors whose effects on profits (income) are corrected in the period after the error.

As discussed above, if the ending inventory is undervalued then the COGS would be overvalued. If the cost of ending inventory is understated then the cost of goods sold would be overstated as the cost of goods sold is the difference between the cost of goods available and the cost of ending inventory. If the ending inventory has been undervalued, the COGS would be overvalued and the gross profit and net profit would be undervalued. So, from the above equation if the cost of ending inventory is undervalued so the Value of cogs would be overvalued. Brian Bass has written about accountancy-related topics and accounting trends for “Account Today.” He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Your cost of goods sold (COGS) is the value of the inventory you sold over a specific time period.

How to Correct Inventory Errors On Your Dealerships’ Financial Statement

Below is the related income statement that shows the impact from overstating inventory. As you can see, cost of goods would be overstated which understates gross profit and net income. When What Are The Effects Of Overstating Inventory? an ending inventory overstatement occurs, the cost of goods sold is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement.

What Are The Effects Of Overstating Inventory?

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.

Financial Accounting

It will also cause more problems if the errors aren’t resolved and carry over from one year to the next. Overstating ending inventory will overstate net income, since this is directly related to the cost of goods sold. To calculate the income, the cost of goods sold is subtracted from the revenue. If the cost of goods sold is too low compared to what it should be, this makes the net income appear larger than it actually is.