If inventory is understated at the end of the year, what is the effect on net income?

Definition of Inventory is Understated

If inventory is understated at the end of the year, it means that the amount of inventory being reported is less than the true or correct amount. Some reasons for reporting too little ending inventory could be any or all of the following:

  • Omitting some inventory items when counting the ending inventory
  • Miscounting some inventory items
  • Math errors occurring during the tabulation of the cost of inventory

When the ending inventory is understated, the following financial statement information will be incorrect:

  • The balance sheet at the end of the current accounting period will report too little inventory. This in turn means the amount of current assets, the amount of total assets, the amount of working capital, and related financial ratios will be understated (amounts will be too small). The owner's (or stockholders') equity will also be too low because of the effect on net income (see next bullet point)
  • The income statement for the current period will overstate (report too much) cost of goods sold. This in turn means reporting too little gross profit and too little net income.
  • The income statement for the following accounting period will report too much gross profit and too much net income

Example of Understated Inventory

The formula for the cost of goods sold is:
Cost of beginning inventory + cost of goods purchased = cost of goods available - cost of ending inventory = cost of goods sold.

Assume that the cost of goods available for the year 2021 was $240,000. If the company shows too little of that cost as its ending inventory (say $15,000 instead of $25,000), it will mean that too much cost will appear on the 2021 income statement as the cost of goods sold ($225,000 instead of $215,000).

The formula for the gross profit is: Net sales - cost of goods sold = gross profit. If net sales for 2021 were $300,000, the gross profit will be incorrectly reported as $75,000 ($300,000 - $225,000) instead of the true amount of $85,000 ($300,000 - $215,000).

In 2022, the amount of the beginning inventory is the amount reported as the ending inventory of 2021 ($15,000 instead of $25,000). If the net purchases during 2022 are $270,000, the cost of goods available will be $285,000 (instead of $295,000). After subtracting the 2022 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). This means that the cost of goods sold for 2022 will be too low by $10,000. If net sales are $325,000, the gross profit will be $70,000 ($325,000 - $255,000) instead of $60,000 ($325,000 - $265,000). This means the gross profit will too low.

Recap: the gross profit in 2021 was understated by $10,000 ($75,000 instead of the true $85,000). The gross profit in 2022 was overstated by $10,000 ($70,000 instead of the true $60,000). One error in calculating the ending inventory of 2021 caused the individual income statements of 2021 and 2022 to report incorrect gross profits and incorrect net incomes. (In our example, only the balance sheet for December 31, 2021 reported the incorrect amounts of inventory and owner's equity.)

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