How to Correct Inventory Errors in Financial Statements

How To Correct Inventory Errors December 18, 2020

Chloe Henderson

Writer

Whether a business uses automatic or manual inventory tracking methods, the establishment must carefully monitor stock counts and records to catch inaccuracies early. Otherwise, calculations involving inventory counts will generate inaccurate estimates.

By understanding the primary sources of inventory errors and the best preventative practices, companies can reduce the risk of discrepancies.

Effects of Inventory Errors

Just one inventory discrepancy can significantly impact a business's bottom line. When records and physical stock do not match, companies cannot accurately define their financial health. Inventory errors specifically affect-

Cost of Goods Sold

The cost of goods sold (COGS) is the monetary value of the inventory sold within a specific timeframe. COGS is calculated by adding the initial stock with purchases made within the accounting period, minus the closing inventory.

If any of these values are incorrect due to inventory errors, businesses can grossly miscalculate their revenue. By overestimating their COGS, companies will formulate a lower income. On the other hand, underestimating the COGS will lead to a seemingly large income.

Regardless of the type of mistake, erroneous inventory logs can skew a business's perception of their finances.

Balance Sheets

Companies use balance sheets to list their assets and liabilities, including inventory. If a business overestimates its ending inventory, it will produce a lower COGS. On the other hand, underestimated inventory counts will inflate the COGS calculations.

Inaccurate income calculations from COGS estimates will also result in erroneous retained earnings on balance sheets. Retained income is calculated by adding net income and period-ending retained earnings, then subtracting the dividends. Therefore, incorporating false revenue estimates will generate erroneous results.

Journal Entries for Purchasing Errors

Businesses can establish a journal for inventory errors, in which managers record miscalculations and subsequent inventory purchases.

For example, if an organization understates its inventory purchase, they can add to their inventory records and submit a journal entry of the cash difference to balance the books.

Journal Entries to Fix Balance Sheets

If the recorded inventory balance is higher than the actual account, the beginning inventory and retained earnings calculations are significantly higher than the actual values.

For example, understating the inventory by $5,000 would require managers to decrease inventory value and increase retained earnings by $5,000 to correct balance sheets.

Restatements

To resolve inventory discrepancies, businesses can submit restatements correcting the previous income statements and balance sheets. This could decrease the COGS, which would result in an increased net income, and vice versa.

Either way, the inventory value and retained earnings on the balance sheet would also need to be corrected.

Disclosures

After submitting restatements, managers should also draft disclosures that outline the errors and corrections in the income statement and balance sheet. This gives accountants a useful reference when examining the books and checking financial records.

Types and Sources of Inventory Errors

As many financial statements are derived from income and expense calculations, one inventory error can generate multiple erroneous estimates. By understanding the different types of errors that typically occur in inventory systems, businesses can prevent discrepancies-

Incorrect Count - A common human error is incorrect unit counts where the physical product tallies are inaccurate. This results in a higher or lower inventory count than what is on-hand, which later generates an erroneous valuation when the quantity is multiplied by the cost.

Incorrect Unit of Measure - Items may be purchased and stored in different units, making it critical that inventory managers have the correct unit of measurement listed for each product. For example, three units of eggs will equal 36 individual eggs if they are purchased by the dozen. Other products may also be counted by weight or length.

Incorrect Standard Cost - Businesses that use a standard costing system, record items' standard cost on a master file. However, if the actual cost does not match the standard price, the calculated inventory value will be inaccurate.

Incorrect Inventory Layering - Inventory cost layering systems, such as the first in, first out (FIFO) and last in, first out (LIFO) methods, assign a cost to each item based on its location within the system. Depending on if the system is automated or manually handled, system malfunctions and human errors can occur.

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Incorrect Part Number - Even if inventory counts are correct, employees may accidentally assign the tallies to the incorrect part number. Whether part numbers are stored in inventory management software or on a clipboard, workers should double-check the inventory figures before submitting quantities.

Customer Owned Inventory - Purchased inventory sitting at the facility could accidentally be counted towards the available stock.

Consignment Inventory - Businesses that use consignment shops and distribution centers may forget to include inventory counts from each site.

Improper Cutoff - If a shipment arrives during a cycle count, employees must wait until the invoice reaches the accounting department before including the delivery in their records.

Transfer Imbalance - Some inventory management systems may require manual entries when transferring items from one location to another. Employees must be sure to add and subtract inventory counts from the correct sites to avoid under and overstating stock levels.

Incorrect Scrap Relief from Backflushing - Backflushing reduces the inventory records balance based on the number of finished products produced, assuming the standard component quantities are correct on the bill of materials. However, if there are any scraps or spoilage, there needs to be an additional system to record these discrepancies.

While every business is bound to experience inventory discrepancies, management can minimize errors by understanding its common sources.