Impact of Inventory Valuation Errors

6/16/2021 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
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PRINCIPLES OF ACCOUNTING, VOLUME 1: FINANCIAL ACCOUNTING
CONTENTS
Inventory
63.
Explain and Demonstrate the Impact of

Inventory Valuation Errors on the
Income Statement and Balance Sheet
Because of the dynamic relationship between cost of goods sold and merchandise inventory, er-
rors
Previous:
in inventory counts
Calculate haveofaGoods
the Cost directSold
andand
significant impactUsing
Ending Inventory on the
thefinancial
Perpetual statements
Method of the
company. Errors in inventory valuation cause mistaken values to be reported for merchandise in-
Next: Examine the Efficiency of Inventory Management Using Financial Ratios
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6/16/2021 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet – Principles of Accountin…
ventory and cost of goods sold due to the toggle effect that changes in either one of the two ac-
counts have on the other. As explained, the company 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
1. beginning inventory (unsold goods left over from the previous period’s operations); and
2. purchases of additional inventory during the current period.
These available inventory items (goods available for sale) will be handled in one of two ways:
1. 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
2. be unsold and held in ending inventory, to be passed into the next period, and reported as
merchandise 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 (merchandise inventory balances) and
inventory expense (cost of goods sold) highlights the impact of errors. Errors in the valuation of
ending merchandise inventory, which is on the balance sheet, produce an equivalent correspond-
ing 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 in-
ventory 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 un-
derstates net income. So over a two-year period, this corrects itself. 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.)
In periodic inventory systems, inventory errors commonly arise from careless oversight of physi-
cal counts. Another common cause of periodic inventory errors results from management neglect-
ing
Previous:
to take the physical count. Both perpetual and periodic updating inventory systems also face
Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
potential errors relating to ownership transfers during transportation (relating to FOB shipping
point and FOB destination terms); losses in value due to shrinkage, theft, or obsolescence; and
consignment inventory, the goods for which should never be included in the retailer’s inventory
but should be recorded as an asset of the consignor, who remains the legal owner of the goods un-
til they are sold.
Calculated Income Statement and Balance Sheet Effects for Two Years
Let’s return to The Spy Who Loves You Company dataset to demonstrate the effects of an inven-
tory error on the company’s balance sheet and income statement. Example 1 (shown in (Figure))
depicts the balance sheet and income statement toggle when no inventory error is present. Exam-
ple 2 (see (Figure)) shows the balance sheet and income statement inventory toggle, in a case
when a $1,500 understatement error occurred at the end of year 1.
Example 1. Assume these values to be correct (no inventory error). This chart shows ex-
cerpted values from The Spy Who Loves You Company’s financial statements without inven-
tory errors. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Example 2. Assume these values to be incorrect (with inventory error). This chart shows ex-
cerpted values from The Spy Who Loves You Company’s financial statements with inventory
errors. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Previous: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
Comparing the two examples with and without the inventory error highlights the significant effect
the error had on the net results reported on the balance sheet and income statements for the two
years. Users of financial statements make important business and personal decisions based on the
data they receive from the statements and errors of this sort provide those users with faulty infor-
mation that could negatively affect the quality of their decisions. In these examples, the combined
net income was identical for the two years and the error worked itself out at the end of the second
year, yet year 1 and year 2 were incorrect and not representative of the true activity of the busi-
ness for those periods of time. Extreme care should be taken to value inventories accurately.
Key Concepts and Summary
The value for cost of the goods available for sale is dependent on accurate beginning and
ending inventory numbers. Because of the interrelationship between inventory values and
cost of goods sold, when the inventory values are incorrect, the associated income statement
and balance sheet accounts are also incorrect.
Inventory errors at the beginning of a reporting period affect only the income statement.
Overstatements of beginning inventory result in overstated cost of goods sold and under-
stated net income. Conversely, understatements of beginning inventory result in understated
cost of goods sold and overstated net income.
Inventory errors at the end of a reporting period affect both the income statement and the
balanceCalculate

Previous: sheet. Overstatements
the Cost of Goodsof ending
Sold inventory
and Ending result
Inventory in understated
Using cost of
goods sold,
the Perpetual Method
overstated net income, overstated assets, and overstated equity. Conversely, understatements
of ending inventory result in overstated cost of goods sold, understated net income, under-
stated assets, and understated equity.
(Figure)Which of the following financial statements would be impacted by a current-year ending

inventory error, when using a periodic inventory updating system?
A. balance sheet
B. income statement
C. neither statement
D. both statements
(Figure)Which of the following would cause periodic ending inventory to be overstated?
A. Goods held on consignment are omitted from the physical count.
B. Goods purchased and delivered, but not yet paid for, are included in the physical count.
C. Purchased goods shipped FOB destination and not yet delivered are included in the physical
count.
D. None of the above
(Figure)How long does it take an inventory error affecting ending inventory to correct itself in the
financial statements? Explain.
(Figure)What type of issues would arise that might cause inventory errors?
Causes of inventory errors might be related to consigned goods, goods delivered before or after
the title transfers, sloppy inventory counts, lost records, calculation errors, and any other circum-
stance that causes inaccuracy in the counts.
(Figure)If a group of inventory items costing $15,000 had been omitted from the year-end inven-
tory count, what impact would the error have on the following inventory calculations? Indicate
the effect (and amount) as either (a) none, (b) understated $______, or (c) overstated $______.


Inventory Item None or amount? Understated or overstated?
Beginning Inventory
Purchases
Goods Available for Sale
Ending Inventory
Cost of Goods Sold
(Figure)If Wakowski Company’s ending inventory was actually $86,000 but was adjusted at year
end to a balance of $68,000 in error, what would be the impact on the presentation of the balance
sheet and income statement for the year that the error occurred, if any?
(Figure)Shetland Company reported net income on the year-end financial statements of $125,000.
However, errors in inventory were discovered after the reports were issued. If inventory was un-
derstated by $15,000, how much net income did the company actually earn?
(Figure)If a group of inventory items costing $3,200 had been double counted during the year-end
inventory count, what impact would the error have on the following inventory calculations? Indi-
cate the effect (and amount) as either (a) none, (b) understated $______, or (c) overstated
$______.

Inventory Item None or amount? Understated or overstated?
Beginning Inventory
Purchases
Goods Available for Sale
Ending Inventory
Cost of Goods Sold
(Figure)If Barcelona Company’s ending inventory was actually $122,000, but the cost of con-
signed goods, with a cost value of $20,000 were accidentally included with the company assets,
when making

Previous: the year-end
Calculate the Costinventory adjustment,
of Goods Sold and Endingwhat would
Inventory be the
Using impact on
the Perpetual the presentation of
Method
the balance sheet and income statement for the year that the error occurred, if any?
(Figure)Tanke Company reported net income on the year-end financial statements of $850,200.
However, errors in inventory were discovered after the reports were issued. If inventory was over-
stated by $21,000, how much net income did the company actually earn?
(Figure)Company Elmira reported the following cost of goods sold but later realized that an error
had been made in ending inventory for year 2021. The correct inventory amount for 2021 was
32,000. Once the error is corrected, (a) how much is the restated cost of goods sold for 2021? and
(b) how much is the restated cost of goods sold for 2022?
(Figure)Assuming a company’s year-end inventory were overstated by $5,000, indicate the effect
(overstated/understated/no effect) of the error on the following balance sheet and income state-
ment accounts.
A. Income Statement: Cost of Goods Sold
B. Income Statement: Net Income

C. Balance Sheet: Assets
D. Balance Sheet: Liabilities

E. Balance Sheet: Equity
(Figure)Company Edgar reported the following cost of goods sold but later realized that an error
had been made in ending inventory for year 2021. The correct inventory amount for 2021 was
12,000. Once the error is corrected, (a) how much is the restated cost of goods sold for 2021? and
(b) how much is the restated cost of goods sold for 2022?

(Figure)Assuming a company’s year-end inventory were understated by $16,000, indicate the ef-
fect (overstated/understated/no effect) of the error on the following balance sheet and income
statement accounts.
A. Income Statement: Cost of Goods Sold

B. Income Statement: Net Income
C. Balance Sheet: Assets
D. Balance Sheet: Liabilities

E. Balance Sheet: Equity
(Figure)Consider the dilemma you might someday face if you are the CFO of a company that is
struggling to satisfy investors, creditors, stockholders, and internal company managers. All of
these financial statement users are clamoring for higher profits and more net assets (also known
as equity). If at some point, you suddenly found yourself not meeting the internal and external
earnings and equity targets that these parties expect, you would probably search for some way to
make the financial statements look better. What if your boss, the CEO, suggested that maybe you
should make just one simple journal entry to record all the goods that your company is holding on
consignment, as if that significant amount of goods were owned by your company? She might say
that this action on your part would fix a lot of problems at once, since adding the consigned goods
to merchandise inventory would simultaneously increase net assets on the balance sheet and in-
crease net income on the income statement (since it would decrease cost of goods sold). How
would you respond to this request?
Write a memo,

Previous: detailing
Calculate yourofwillingness
the Cost or Ending
Goods Sold and not to Inventory
embraceUsing
this suggestion,
the Perpetualgiving reasons be-
LICENSE SHARE THIS BOOK Method
hind your decision. Remember to exercise diplomacy, even if you must dissent from the opinion
of a supervisor. Note that the challenge of the assignment is to keep your integrity intact while
also keeping your job, if possible.
Principles of Accounting, Volume 1:

Financial Accounting by
OSCRiceUniversity is licensed under a
Creative Commons Attribution-
NonCommercial-ShareAlike 4.0
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6/16/2021 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

ce Sheet – Principles of Accountin…

Home Read Sign in

PRINCIPLES OF ACCOUNTING, VOLUME 1: FINANCIAL ACCOUNTING

Explain and Demonstrate the Impact of

1. be sold to customers (normally) or be lost due to shrinkage, spoilage, or theft (occasionally),

Next: Examine the Efficiency of Inventory Management Using Financial Ratios

Key Concepts and Summary

(Figure)Which of the following financial statements would be impacted by a current-year ending

(Figure)Which of the following would cause periodic ending inventory to be overstated?

A. Goods held on consignment are omitted from the physical count.

D. None of the above

Next: Examine the Efficiency of Inventory Management Using Financial Ratios

A. Income Statement: Cost of Goods Sold

B. Income Statement: Net Income

D. Balance Sheet: Liabilities

Next: Examine the Efficiency of Inventory Management Using Financial Ratios

A. Income Statement: Cost of Goods Sold

D. Balance Sheet: Liabilities

Principles of Accounting, Volume 1:

Guides and Tutorials | Contact

Next: Examine the Efficiency of Inventory Management Using Financial Ratios

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