Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 5 Accounting for Merchandise Operations 231

EFFECTS OF INVENTORY MISSTATEMENTS

ON THE FINANCIAL STATEMENTS

Any error in the physical inventory count at the end of the accounting period affects

the income statement and balance sheet. This is because the physical inventory count

is the basis for determining the amount of inventory shrinkage. As we illustrated in

the preceding section, the adjusting entry for inventory shrinkage affects the cost of

merchandise sold and merchandise inventory. Thus, if the physical inventory is mis-

stated, then the amount of inventory shrinkage is misstated and the cost of merchan-

dise sold will be misstated after the inventory shrinkage adjustment is recorded.

Because net income is closed to Retained Earnings at the end of the accounting period,

retained earnings and total assets are misstated. This misstatement of total assets,

current assets, and merchandise inventory equals the misstatement of stockholders’

equity. These effects are shown in Exhibit 12.

Describe and illustrate the
effects of inventory mis-
statements on the financial
statements.

8

Exhibit 12

Effects of Inventory Misstatements

Income Statement Effects

Physical Inventory Cost of Gross Net

Inventory Shrinkage Merchandise Profit Income

Misstatement Misstated Sold Misstated Misstated Misstated

Balance Sheet Effects

Physical Adjusted Current Total Retained Total

Inventory Merch. Inv. Assets Assets Earnings Stockholders’ Equity

Misstatement Misstated Misstated Misstated Misstated Misstated

To illustrate, assume that in taking the physical inventory on December 31, 2008,

Sapra Company incorrectly counted its physical inventory as $115,000 instead

of $125,000. Because the ending physical inventory is understated, the inventory

shrinkage and the cost of merchandise sold will be overstated by $10,000, as shown

below.

Amount of Misstatement

Overstated (Understated)

December 31, 2008, unadjusted book inventory Correct

Less December 31, 2008, physical inventory $(10,000)

Inventory shrinkage (cost of merchandise sold) $ 10,000

Recall from the preceding section that the amount of inventory shrinkage is

recorded by adjusting the cost of merchandise sold. Thus, an overstatement of the

inventory shrinkage overstates the cost of merchandise sold. Because the cost of

merchandise sold is overstated, gross profit and net income for 2008 will be under-

stated by $10,000. Since net income is closed to Retained Earnings at the end of 2008,

the total stockholders’ equity on the December 31, 2008, balance sheet will also be un-

derstated by $10,000.