How Does Understated Ending Inventory Affect Equity?
Despite your best intentions, mistakes can be made while preparing company financial records. Once you've identified that you've made a mistake, it can be useful to know how that error affects the conclusions you've arrived at. A common error, understatement of inventory, is usually caused by counting inaccuracy during the company's annual inventory count. Understating inventory causes a decrease in equity. However, knowing more about ways that inventory can be understated can help you identify situations where you may need to look closer at your financial statements.
If inventory is miscounted during the company's annual inventory count, this could cause inventory to be understated. Understated inventory balances will inflate the company's cost of goods sold relative to sales. This occurs because it will look like the company used more resources than it actually did relative to the level of sales recorded. If the cost of goods sold is overstated, that means that the overall expense will be too high as well. If expense is overstated, then net income will be understated. Lastly, this leads to an understatement of equity.
Miscounting inventory doesn't just have an effect in the period that the balance was miscounted. Because the ending inventory for one year is the beginning inventory in the next year, the next year will be misstated as well, but in the opposite direction. Therefore, if ending inventory is understated in the current year, it will be overstated in the subsequent year. This means that cost of goods sold will be understated, total expense will be understated, net income will be overstated and equity will be overstated.
Employee or customer theft can cause inventory to go missing, which is known as shrink. If the differences are found and corrected during the company's annual inventory count at the end of the year, then inventory will be properly stated on an accounting basis. Even though it may seem like this should be considered an understatement of inventory, the equity balance will be correct. Although the balance is correct and the accounting records will be accurate, shrink increases cost of goods sold, total expense and reduces profit and equity, as compared to what these balances could have been. Accordingly, you should work to identify opportunities to control shrink before you find the missing goods during the annual count.
An understated inventory balance can also be caused by incorrect costing information. The cost recorded of inventory on the company's balance sheet is a function of the number of units recorded and the cost of the units. Quantity issues are identified during the company's inventory count. However, costing issues can be more difficult to troubleshoot. For manufacturing companies, understated inventory costs can be related to inaccurate prices for materials in the company's accounting information system, failure to account for taxes and benefits for production employees or forgetting to account for all inventory costs. Whether the inventory understatement is caused by quantity or price issues, the effect on equity is the same -- inventory understatement leads to equity understatement.