Inventory is a line item on your balance sheet and cost of goods sold (COGS) to calculate net income on your income statement. If your inventory records have any errors, they can affect your financial statements and create an inaccurate financial picture.
Let’s look at this in more detail, then we will talk about correcting financial errors on your financial statements.
Your cost of goods sold (COGS) is the value of the inventory you sold over a specific time period. This time of year, you are probably looking at your annual COGS.
To calculate COGS, you want to add your opening inventory to purchases during the year and subtract closing inventory. If you use inventory management software, it should calculate this number for you on your income statement.
If you overestimate your COGS, you’ll have lower net income (beginning inventory too high and/or ending inventory too low). Under current assets on your balance sheet, ending inventory will also be understated.
If COGS is understated (beginning inventory too low and/or ending inventory too high), then your ending inventory on your balance sheet will be too high and current assets will be overstated. You’ll also have a higher net income. Inaccurately reported income will also affect the retained earnings listed on the balance sheet.
In either instance, inaccurate inventory will give you misinformation about your company’s performance, which can result in poor decision making. It will also cause more problems if the errors aren’t resolved and carry over from one year to the next.
So how do you correct the errors to ensure you are properly reporting your financial position? You will need to record a reverse journal entry in the period you discover the error. Here are some examples:
- Correcting a purchasing error
You overstated an inventory purchase – debit your cash account and credit your inventory account by the overstated amount.
You understated an inventory purchase – debit inventory and credit cash for the understated amount.
- Correcting a balance sheet error
Previous year’s inventory was understated (leading to the current year’s beginning inventory being understated) – debit inventory and credit retained earnings by the overstatement in the new year.
Previous year’s ending inventory was overstated (leading to the current year’s beginning inventory being overstated) – debit retained earnings and credit inventory by the understatement in the new year.
You must also restate the prior year’s income statement and balance sheet when you find an inventory error.
Inventory balance was overstated – increase COGS on the income statement, which will decrease net income; decrease ending inventory and decrease retained earnings on the balance sheet.
Inventory balance was understated – decrease COGS on the income statement, which will increase net income; also increase ending inventory and increase retained earnings on the balance sheet.
And remember, always write disclosure notes in the journal entry and on the financial statements to explain the nature and impact of the error. This will ensure viewers of the financial statements know about the previous issues and corrections.
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Tags: Auto Parts Inventory