Accounting: The Language of Business (Part 50)

“Only accountants can save the world – through peace, goodwill and reconciliations.” —Unknown

Inventories (Part B)

by

Charles Lamson

Effect of Inventory Errors on Financial Statements

Any errors in the inventory count will affect both the balance sheet and the income statement. For example, an error in the physical inventory will misstate the ending inventory, current assets, and total assets on the balance sheet. This is because the physical inventory is the basis for recording the adjusting entry for inventory shrinkage. Also, an error in taking the physical inventory misstates the cost of goods sold, gross profit, and net income on the income statement. In addition, because net income is closed to the owner's equity at the end of the period, owner's equity will also be misstated on the balance sheet. The misstatement of owner's equity will equal the misstatement of the ending inventory, current assets, and total assets.

To illustrate, assume that in taking the physical inventory on December 31, 2023, Sapra Company incorrectly recorded its physical inventory as $115,000 instead of the correct amount of $125,000. As a result, the merchandise inventory, current assets, and total assets reported on the December 31, 2023 balance sheet would be understated by $10,000 ($125,000 - $115,000). Because the ending physical inventory is understated, the inventory shrinkage in the cost of merchandise sold will be overstated by $10,000. Thus, the gross profit and the net income for the year will be understated by $10,000. Since the net income is closed to owner's equity at the end of the period, the owner's equity on December 31, 2023 balance sheet will also be understated by $10,000. The effects on a company's financial statements are summarized as follows:

Now assume that in the preceding example the physical inventory had been overstated on December 31, 2023, by $10,000. That is, Sapra Company erroneously recorded its inventory as $135,000. In this case, the effect on the balance sheet and income statement would be just the opposite of those indicated above.

Errors in the physical inventory are normally detected in the period after they occur. In such cases, the financial statements of the prior year must be corrected. We will discuss such corrections in a later post.

Inventory Cost Flow Assumptions

A major accounting issue arises when identical units of merchandise are acquired at different unit costs during a period. In such cases, when an item is sold, it is necessary to determine its unit cost so that the proper accounting entry can be recorded. To illustrate, assume that three identical units of item X are purchased during May, as shown below.

Assume that one unit is sold on May 30 for $20. If this unit can be identified with a specific purchase, the specific identification method can be used to determine the cost of the unit sold. For example, if the unit sold was purchased on May 18, the cost assigned to the unit is $13 and the gross profit is $7 ($20 - $13). If, however, the unit sold was purchased on May 10, the cost assigned to the unit is $9 and the gross profit is $11 ($20 - $9).

The specific identification method is not practical unless each unit can be identified accurately. An automobile dealer, for example, may be able to use this method, since each automobile has a unique serial number. For many businesses, however, identical units cannot be separately identified, and a cost flow must be assumed. That is, which units have been sold and which units are still in inventory must be assumed.

There are three common cost flow assumptions used in business. Each of these assumptions is identified with an inventory costing method.

When the first-in, first-out (fifo) method is used, the inventory is made up of the most recent costs. When the last-in, first-out (lifo) method is used, the ending inventory is made up of the earliest costs. When the average cost method is used, the cost of the units in inventory is an average of the purchase costs.

The selection of an inventory costing method can have a significant impact on the financial statements. For this reason, the selection has important implications for managers and others in analyzing and interpreting the financial statements.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 357-360*

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