If ending inventory for a year is overstated, then gross profit for that year will be overstated.
Importance of proper inventory valuationA merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, the cost of inventory sold is recorded as cost of goods sold. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet. Show Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. 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. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings. Exhibit 3 summarizes the effects of errors of inventory valuation:
Exhibit 3: Inventory errors Licenses and AttributionsCC licensed content, Shared previously
Income statement effects. An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. Left unchanged, the error has the opposite effect on cost of goods sold, gross profit, and net income in the following accounting period because the first accounting period's ending inventory is the second period's beginning inventory. The total cost of goods
sold, gross profit, and net income for the two periods will be correct, but the allocation of these amounts between periods will be incorrect. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct. The chart below identifies the effect that an incorrect inventory balance has on the income statement. Impact of Error on Error in Inventory Cost of Goods Sold Gross Profit Net Income Ending Inventory Understated Overstated Understated Understated Overstated Understated Overstated Overstated Beginning Inventory Understated Understated Overstated Overstated Overstated Overstated Understated Understated Balance sheet effects. An incorrect inventory balance causes the reported value of assets and owner's equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period. Impact of Error on Error in Inventory Assets = Liabilities + Owner's Equity Understated Understated No Effect Understated Overstated Overstated No Effect Overstated What happens to gross profit If ending inventory is overstated?An overstated inventory will inflate gross profits and conversely understating inventory will have a negative impact on gross profits.
Which is true if the ending inventory is overstated?If the ending inventory is overstated, what occurs? It will have the reverse effect on the net income during the next accounting period.
What happens if the ending inventory is understated?When the inventory asset is understated at the end of the year, then income for that year is also understated. The reason is that, if costs are not included in inventory, then by default they must have been included in the cost of goods sold.
What happens to gross profit if closing inventory is undervalued?If the company shows too little of that cost as its ending inventory (say $15,000 instead of $25,000), it will mean that too much cost will appear on the 2021 income statement as the cost of goods sold ($225,000 instead of $215,000). The formula for the gross profit is: Net sales - cost of goods sold = gross profit.
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