6.3 Analyse the effects of inventory errors
Mitchell Franklin; Patty Graybeal; Dixon Cooper; and Rina Dhillon
The effects of inventory errors
Because of the dynamic relationship between cost of goods sold and inventory, errors in inventory counts have a direct and significant impact on the financial statements of the business. Errors in inventory valuation cause mistaken values to be reported for inventory and cost of goods sold due to the toggle effect that changes in either one of the two accounts have on the other. As explained, the business has a finite amount of inventory that they can work with during a given period of business operations, such as a year. This limited quantity of goods is known as goods available for sale and is sourced from
- beginning inventory (unsold goods left over from the previous period’s operations); and
- purchases of additional inventory during the current period.
These available inventory items (goods available for sale) will be handled in one of two ways:
- be sold to customers (normally) or be lost due to shrinkage, spoilage, or theft (occasionally), and reported as cost of goods sold on the income statement; OR
- be unsold and held in ending inventory, to be passed into the next period, and reported as inventory on the balance sheet.
Fundamentals of the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
Understanding this interaction between inventory assets (inventory balances) and inventory expense (cost of goods sold) highlights the impact of errors. Errors in the valuation of ending inventory, which is on the balance sheet, produce an equivalent corresponding error in the company’s cost of goods sold for the period, which is on the income statement. 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.
Further, 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. Over 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. So over a two-year period, this corrects itself. This is an example of counterbalancing errors, or errors whose effects on profits (income) are corrected in the period after the error. 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.). However not all inventory errors are counterbalancing. For example, if a particular warehouse of inventory is not counted year after year, the error will not work itself out.
In periodic inventory systems, inventory errors commonly arise from careless oversight of physical counts. Another common cause of periodic inventory errors results from management neglecting to take the physical count. Both perpetual and periodic inventory systems also face potential errors relating to losses in value due to shrinkage, theft, or obsolescence.
