Proper inventory valuation is important when accounting for inventory through financial reporting. If inventory is not correctly valued inventory discrepancies will impact financial statements such as balance sheets, income statements and statements of retained earnings.
When accounting for inventory the recorded amount is the total quantity and value of raw materials, work-in-progress and finished goods that a business owns. The value of this inventory must be calculated correctly because it accounts for a significant share of the business’s current assets. Which in turn determines the amount of profit or loss the business generates.
Accounting for inventory
In each accounting period, any applicable expenses must correspond with revenue earnt to determine the business’ net income. When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues.
A periodic inventory method works on a system that calculates the cost of the goods sold (COGS). This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock.
The end inventory is subtracted from this stock, to provide the total COGS. The net income for an accounting period will directly depend on the valuation of the ending inventory.
The four common costing methods in the periodic inventory method are:
- First In, First Out (FIFO)
- Specific Identification method
- Weighted Average method – this is the method Unleashed Software uses
- Last In, First Out (LIFO)
Any of the four costing approaches in the periodic inventory method will produce a different result over the same accounting period. Therefore, it is necessary and often a legal requirement, for one method to be chosen and applied consistently across future reporting periods to maintain accuracy.
At the end of an accounting period, the total value of items to be sold, often acknowledged as stock-in-hand, is recorded as inventory under current assets.
Inventory discrepancies occur between the value of inventory captured in records and the value of the actual inventory held.
Variations in COGS will have a direct impact on a company’s income statements because the COGS is subtracted from sales to get the gross profit. An overstated inventory will inflate gross profits and conversely understating inventory will have a negative impact on gross profits.
Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers. This discrepancy can be caused by theft, damage, fraud or incorrect inventory counts and administrative errors.
When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS. When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated.
Understated inventory, on the other hand, increases the cost of goods sold. Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS.
An understated inventory indicates there is less inventory on hand than the actual stock amount. This can arise from errors in receipting stock, failure to reconcile the movement of raw materials and finished goods from one location to another and unrecorded transactions.
Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement.
Reconciling inventory discrepancies
When a business misrepresents its ending inventory, the company carries forward that mistake through to the following accounting period because the ending inventory amount of the current year is the beginning inventory amount for the next year.
An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS. Conversely, in understated inventory, an adjustment entry needs to be made to remove the surplus stock, which in turn reduces closing stock to the correct level and increases the COGS.
Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count. It is necessary to compare the inventory counts recorded to actual quantities on the warehouse shelves and assess why differences have occurred before adjusting the data to reflect this analysis.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.