An income statement summarizes revenue and expenses for a given period. Its purpose is to show total sales against expenses and determine the amount of profit or loss incurred. Beginning and ending inventory can help a business determine expenses during the period covered by an income statement. Normally, the inventory value at the end of an accounting period is reported as an asset on company balance sheets. Beginning and ending inventory are not always listed on income statements, but both values are necessary to calculate cost of goods sold to charge against gross sales.
Incorrect values for inventory will cause errors in the calculation of cost of goods sold, and that results in inaccurate conclusions about profit or loss during an accounting period. Correct valuation and physical counts of inventory are important in determining a business's profit or loss.
Inaccurate accounting will cause errors in the income statement. An understated beginning inventory causes gross profit and net income to be overstated. Overstating beginning inventory results in understated gross profit and net income. Results are comparable in the case of ending inventory. When ending inventory is understated, it results in understated income. Overstatement of ending inventory results in overstated income.
The formula to determine cost of goods sold is: Beginning Inventory + Net Inventory Purchases = Cost of Goods Available. The Cost of Goods Available - Ending Inventory = Cost of Goods Sold.
Assume beginning inventory was $1,000. Net purchases of $500 were made during the period, resulting in a total cost of goods available of $1,500. Assume the ending inventory for the period is $750. Subtract $750 from $1,500 to arrive at the cost of goods sold, which is $750.
A simplified version of the formula for cost of goods sold is: Cost of Goods Available - Ending Inventory = Cost of Goods Sold.
Once a total cost of goods sold has been calculated, the result is subtracted from total sales for the period. Using the previous example, the cost of goods sold was $750. Assume total sales for the period were $1,750. Subtracting $750 from $1,750 leaves $1,000 gross profit, before deducting operating expenses and taxes.
While beginning and ending inventory are necessary to compute cost of goods sold, they may or may not appear on an income statement. Income statements often omit the calculations to arrive at an amount and simply list the cost of goods sold as a one-line entry on the income statement. The accuracy of inventory is essential to creation of accurate income statements that are useful in making good business decisions.
