Question: Inventory appears on different financial documents including balance sheets. These amounts can affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet as Current Assets which is reported in an order that descends in terms of liquidity. Because inventories are converted into cash within a year or a single operating cycle, inventories will usually come after cash and receivables on the balance sheet itself. Inventory errors can be identified as overstatements and understatements. An error occurring with inventory will affect the income statement and balance which is part of the cost of goods sold on the income statement. Being able to calculate this means the inventory turnover will identify how quickly the inventory can be sold as well as the rate required to replace it.(Lumen Learning, 2014) As an accountant it's important to understand if an inventory is overstated or understated.
A good way to find out if something was overstated or understated is to first identify the cost of goods sold, gross profit and net income on the income statement. Once the beginning inventory is established, the cost of goods sold will be understated by the error amount. Because of this, the net income and gross profit are overstated. When looking at ending inventory, your cost of goods sold will be overstated by the error amount, and net income and gross profit will be understated. If the beginning inventory is understated, the cost of goods sold is overstated, and gross profit and net income are understated. If the ending inventory was overstated, the cost of goods is understated, and gross profit as well as net income are overstated. This can be very confusing but taking it one step at a time and understanding the concept of overstating and understating will prevent further errors being recorded. The next step would be to find the total assets and total amount of stockholder's equity on the balance sheet. If the inventory was understated, then the total assets is understated and the stockholder's equity is overstated. If you overstated inventory, then your total assets are overstated and your stockholder's equity is understated. (McBride, 2017) Overall, being very thorough with identifying inventory errors is crucial to success in financial accounting
References: Lumen Learning. (2014) Impacts of Inventory Errors on Financial Statements. Financial Accounting.
McBride, Carter. (2014) How to Determine the Effects of Inventory Errors and Calculate Inventory Turnover. Chron.