Inventory errors are often self correcting, meaning that an error in ending inventory Will have a reverse effect on net income in the next accounting period. So over two years, the total net income is correct because the errors offset each other.
Under FIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower. Under LIFO: Ending Inventory is higher, and total current assets are higher; cost of goods sold is lower, and gross profit is higher. Ending inventory is the value of goods available for sale at the end of an accounting period. It is the beginning inventory plus net purchases minus cost of goods sold.
Net purchases refer to inventory purchases after returns or discounts have been taken out. Inventory values can be calculated by multiplying the number of items on hand with the unit price of the items.
The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. There are four accepted methods of costing the items: 1 specific identification; 2 first-in, first-out FIFO ; 3 last-in, first-out LIFO ; and 4 weighted-average.
Valuation Rule The rule for reporting inventory is that it must be valued at acquisition cost or market value, whichever is the lower amount. In general, inventories should be valued at acquisition costs. Inventory is a reduction of your gross receipts.
The cost of inventories flows as expenses into the cost of goods sold COGS and shown as expenses items in the income statement.
Inventory is not directly taxable as it is cannot be bought or sold. Applied to inventory, matching involves determining 1 how much of the cost of goods available for sale during the period should be deducted from current revenues and 2 how much should be allocated to goods on hand and thus carried forward as an asset merchandise inventory in the balance sheet to be matched against future revenues.
Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:. Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income.
If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income are understated. Note, however, that when net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct.
When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated. Understated inventory, on the other hand, increases the cost of goods sold. Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS. An understated inventory indicates there is less inventory on hand than the actual stock amount. This can arise from errors in receipting stock, failure to reconcile the movement of raw materials and finished goods from one location to another and unrecorded transactions.
Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement. When a business misrepresents its ending inventory, the company carries forward that mistake through to the following accounting period because the ending inventory amount of the current year is the beginning inventory amount for the next year. An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS.
Conversely, in understated inventory, an adjustment entry needs to be made to remove the surplus stock, which in turn reduces closing stock to the correct level and increases the COGS. Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count. It is necessary to compare the inventory counts recorded to actual quantities on the warehouse shelves and assess why differences have occurred before adjusting the data to reflect this analysis.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years.
When not writing about inventory management, you can find her eating her way through Auckland. As a business owner, you may feel the pressure when inventory managem Demand forecasting is the process of estimating the number of products that customers will be willing to purchase in the future.
It involves leveragin Shipping products out to your customer base can be an exciting time.
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