Impact of Inventory Errors on financial statements
Inventory errors are very common among the accounting errors. There might be many reasons, however, the impact of inventory errors on financial statements is really alarming.
Inventory management is no doubt very tricky and complex. Even a single error can bring troubles and affect both, the income statement and the balance sheet. Let’s see the common reasons for inventory errors.
Reasons for inventory errors
In most cases, inventory errors are caused by miscounting of the physical inventory, but there are many other reasons as well.
- Physical miscount of inventory due to theft of inventory
- Failure to record the damage of inventory
- Failure to record an inventory issuance and failure to record a receipt
- Incorrect costs assigned to inventory
- Inventory in transit not dealt with correctly
Impact of inventory errors on the income statement
Inventory errors are fairly straightforward and affect the financial performance of the business entity. The simplest way is to trace out the actual errors before we fix them. Once we find out the errors we can rectify them accordingly.
Here is another important point to note: opening inventory errors only affect the income statement while ending inventory errors affect both, the income statement and balance sheet.
We understand that the ending inventory of one period automatically becomes the beginning inventory of the next period. So, inventory errors affect the calculation of the cost of goods sold and net income in two periods(Current and the next accounting period). Let’s understand this by the following illustration.
Now, let’s clarify the above illustration with very simple words. When beginning inventory is understated, it affects the cost of goods sold positively while it affects inversely on net income. It is because the opening inventory is usually consumed in the current accounting period, so it is added to the cost of goods sold. Therefore both have a direct impact on each other.
Moreover, an error in the ending inventory of the current accounting period will have a reverse effect on the net income of the next accounting period. It is because the understatement of ending inventory in the current accounting period will understate the beginning inventory of the next accounting period and overstate the net income of next accounting period as well.
Impact of inventory errors on the balance sheet
Inventory errors have an extreme impact on the balance sheet as well. We can determine these errors with the help of a basic accounting equation. Let’s understand this with illustration 2.
In addition, the ending inventory error on the previous accounting period will also affect the two accounting periods if not rectified.