The Effect of Overstating Beginning Inventory
Inventory errors can result from several factors, including counting errors, costing inaccuracies and spoilage. The ending inventory of one period is the beginning inventory of the next, which means that overstating or understating one affects the other. If undetected, inventory errors can affect the cost of goods sold, net income and balance sheet accounts for current and subsequent periods, according to the website Accounting Tools.
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Cost of Goods Sold
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Overstating beginning inventory overstates the cost of goods sold, which is an income statement account. It includes raw materials, labor and other direct costs of production. An overstated beginning inventory balance implies an overstated ending inventory balance for the prior period. Cost of goods sold is beginning inventory plus purchases minus ending inventory for a period, which could be a month, quarter or year.
For example, if a business incorrectly valued the prior-year ending inventory at $1.1 million instead of $1 million, then the prior-year ending inventory and the current-year beginning inventory balances are overstated by $100,000 ($1.1 million - $1 million). If the business purchases $500,000 worth of inventory during the year and correctly values the ending inventory at $600,000, then the cost of goods sold using the overstated beginning inventory balance is $1 million ($1.1 million + $500,000 - $600,000) instead of the correct amount of $900,000 ($1 million + $500,000 - $600,000). This overstates cost of goods sold by $100,000 ($1 million - $900,000).
Gross Profit and Net Income
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Overstating beginning inventory understates gross profit and net income. Gross profit is sales minus cost of goods sold. As overstated beginning inventory overstates the cost of goods sold, it understates gross profit. Net income is gross profit minus expenses, such as sales and administrative expenses, interest and taxes. If gross profit is understated, net income must also be understated.
Continuing with the example, if sales are $5 million, the gross profit using the overstated beginning inventory balance is $4 million ($5 million - $1 million) instead of the correct amount of $4.1 million ($5 million - $900,000), thus understating gross profit by $100,000 ($4 million - $4.1 million). If expenses are $2 million, the net income using the overstated beginning inventory balance is $2 million ($4 million - $2 million) instead of the correct amount of $2.1 million ($4.1 million - $2 million). This understates net income by $100,000 ($2 million - $2.1 million).
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Balance Sheet
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Inventory is in the assets section of the balance sheet. If it is overstated, assets also will be overstated. There is no impact on the liabilities section of the balance sheet. However, if the error is corrected -- for example, if the period-ending inventory is correctly counted -- the inventory balance in the balance sheet will be correct. To conclude the example, since the ending inventory was correctly counted at $600,000, this amount should be the inventory balance on the balance sheet.
Considerations: Improving Accuracy
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Bragg recommends several ways of improving inventory accuracy, including installing inventory tracking software, improving warehouse security to prevent unauthorized access and training staff in inventory procedures.
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References
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