Inventory errors can be defined as errors that occur in recording a company’s current inventory at the beginning of an accounting period and the end of it. Inventory is considered to be one of the crucial balance sheet assets because acts as the basis for the company’s planning, strategies, operations, and objectives (Franklin et al., 2019). Inventory items available to the company can be either “sold to customers (or be lost due to shrinkage, spoilage, or theft) or be unsold and held in ending inventory” (Franklin et al., 2019, p. 32). Beginning and ending inventory errors have different negative effects on the elements of the basic accounting equation, such as assets, liability, and owner’s equity.
If the company’s inventory is overstated at the beginning of a given period, it is likely to lead to an increase in owner’s equity, which is a part of the balance sheet equation. At the same time, the liabilities of this business will not be affected. In turn, when the assets are understated, it results in an “understated cost of goods sold and overstated net income” (Franklin et al., 2019, p. 32). When the company’s ending inventory is overstated, its cost of goods is understated. Conversely, the “net income, assets, and equity” of the business are overstated (Franklin et al., 2019, p. 32). In addition, when a company’s inventory is overstated at the beginning of the period, its net income can seem lower than it is in reality. As a result, the company can underpay its income tax, which can lead to penalties and other negative consequences. Understatement of the ending inventory will result in an “overstated cost of goods sold, understated net income, understated assets, and understated equity” (Franklin et al., 2019, p. 34). This decreases taxes that need to be paid by the company, which poses risks for the whole business as well.
Reference
Franklin, M., Graybeal, P., & Cooper, D. (2019). Principles of accounting volume 1 – Financial accounting. OpenStax.