The effect of understated ending inventory

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When the inventory asset is understated at the end of the year, then income for that year is also understated. The reason is that, if costs are not included in inventory, then by default they must have been included in the cost of goods sold. When this happens, costs are transferred from the balance sheet to the income statement, so that some of the inventory asset is incorrectly charged to expense.

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Accounting for Inventory

Example of the Effect of Understated Ending Inventory

A new business buys $1 million of merchandise during a year, and records ending inventory of $100,000, which results in a cost of goods sold of $900,000. However, the ending inventory was undercounted by $30,000, so the ending inventory balance should have been $130,000, which means that the cost of goods sold should have been $870,000. The result is reported profits that are $30,000 lower than is really the case.

What Causes Understated Ending Inventory?

There are several causes of understated inventory. Consider the following possibilities:

  • Record keeping errors. There may be any number of inventory record keeping errors. These are most common when a manual inventory tracking system is in place, or when the warehouse staff is not well trained in recording transactions.

  • Incorrect inventory count. The warehouse staff may not have counted the ending inventory correctly. This is most common when there is not a firm cutoff, where all activity is supposed to cease for the duration of the count. It can also happen when less experienced people are used for the count.

  • Incorrect inventory valuation. The accounting staff may have placed an incorrect valuation on some inventory items. This may be due to an incorrect unit of measure being used for the valuation.

How to Prevent an Understated Ending Inventory

Here are two options to prevent an understated ending inventory from occurring:

  • Implement cycle counting. A business should use cycle counting to continually verify whether its inventory records match its physical inventory.

  • Conduct trend line analysis. A business can review inventory valuations on a trend line to see if there are any unusual spikes or dips in the valuation amounts over time, which may be worthy of further investigation.