AC 210 Lecture Notes - Lecture 42: Gross Profit, Financial Statement, Balance Sheet
5 Jun 2018
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Inventory Errors and Financial Statements
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
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Estimating Inventories
Companies sometimes need to determine the value of inventory when a physical count
is impossible or impractical. For example, a company may need to know how much
inventory was destroyed in a fire. Companies using the perpetual system simply report
the inventory account balance in such situations, but companies using the periodic
system must estimate the value of inventory. Two ways of estimating inventory levels
are the gross profit method and the retail inventory method.
Gross profit method. The gross profit method estimates the value of inventory by
applying the company's historical gross profit percentage to current‐period information
about net sales and the cost of goods available for sale. Gross profit equals net sales
minus the cost of goods sold. The gross profit margin equals gross profit divided by
net sales. If a company had net sales of $4,000,000 during the previous year and the
cost of goods sold during that year was $2,600,000, then gross profit was $1,400,000
and the gross profit margin was 35%.
Net Sales
$ 4,000,000
Less: Cost of Goods Sold
(2,600,000)
Gross Profit
$ 1,400,000
If gross profit margin is 35%, then cost of goods sold is 65% of net sales.
Suppose that one month into the current fiscal year, the company decides to use the
gross profit margin from the previous year to estimate inventory. Net sales for the month
were $500,000, beginning inventory was $50,000, and purchases during the month
totaled $300,000. First, the company multiplies net sales for the month by the historical
gross profit margin to estimate gross profit.
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Document Summary
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. An incorrect inventory balance causes the reported value of assets and owner"s equity on the balance sheet to be wrong.
