When the number of stock recorded in your business’ records do not match up to your physical number of stock counted, this results in stock discrepancies. This is one of the main reasons stocktake is so important as it reveals if any such discrepancies exist.
Discrepancies, if not prevented or detected, can bring about serious damaging consequences, making inventory reconciliation is an extremely important part of stock count. For example, warehouse staff uses stock counting to continually update the accuracy of its inventory records. Inventory record accuracy is needed to ensure that replacement items are ordered in a timely manner, that inventory is properly valued, and that parts are available for sale or production when needed. However, just as important, an inventory reconciliation is also needed to ensure that the actual and recorded inventory stock amounts are the same at the end of the year, so that there are no issues when the inventory is audited.
The value of inventory must be calculated accurately because it accounts for a substantial share of a business’ current assets and determines the value of profits or losses. Stock discrepancies may arise and although inventory adjustments are used to correct these differences to avoid overstating or understating the business’s income statement, the fact is that inventory reconciliation is not as simple as adjusting the book balance to match the physical count. There may be other reasons why there is a difference between the two numbers that cannot be corrected with such an adjustment and especially not as a long-term solution.
Overstated inventory records show there are more stock items in the stores than the actual stock count. The inventory data can be inflated for many reasons, such as when there is theft, damages, deliberate fraud or unintentional computing errors. For example, if a staff member gives a customer a sample of the product, which was mistakenly not deducted from the total inventory count, this shortfall may go unnoticed until a stock count is done. An understated inventory shows there are less stock items recorded in the store than the actual stock count.
An overstated inventory lowers the cost of goods sold. The availability of excess inventory stock in the accounting records ultimately translates to more closing stock or ending inventory and lower COGS. Therefore, when an adjustment entry is made to remove the extra inventory stock, this reduces the amount of ending inventory and increases the COGS.
Understated inventory increases the COGS. Recording lower inventory stock in the accounting records reduces the ending inventory, effectively increasing the COGS. When an adjustment entry is made to add the omitted inventory stock, this increases the amount of ending inventory and reduces the COGS.
Income statement implications
Fluctuations in COGS directly affect a business’ income statement. For instance, you have to subtract COGS from sales to get the gross profit. If you understated the ending inventory, your COGS will be overstated by the error amount, and net income and gross profit are understated. If you overstated beginning inventory, then COGS is overstated, and gross profit and net income are understated.
An increase in COGS due to a downward adjustment of an overstated inventory reduces the gross profits. Inversely, the reduction of COGS as a result of upward adjustment of an understated inventory increases the gross profits. Similar implications affect and apply to the net income, which is calculated by subtracting the operating expenses from the gross profits.
Although stock discrepancies can be adjusted in the balance sheet, it is imperative to uncover the underlying causes of any such discrepancies – this way processes can be implemented to mitigate these. Not only will this save a major headache when it comes to the end of year reconciliation of accounts, but there will be no major nasty surprises of inaccurate inventory data records affecting the balance sheet and income statement.
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.