The inventory is considered to be a hazardous item in the balance sheet. The risk even increases if the business operates in the manufacturing sector. The reason is that business operating in manufacturing segment is expected to have a greater quantity of raw material, work in process, and the finished goods.
A value measurement for inventory
The inventories are to be measure at a lower cost, net realizable value, or (NRV). According to IAS, the acceptable methods for determining the cost of inventories are First-in-First-Out and weighted average cost. On the contrary, according to the US GAAP, Last-in-first-out is also acceptable.
What are inventories:
Inventories are the assets that are held for trading in due course of business. These inventories are known to be the finished goods, the assets being held under the manufacturing process known as the work in progress, or material and supplies consumed during the production process.
Definition:
Inventories are the assets that are held for sale. It is the process of production for making sales. It is in the form of materials consumed during the production process or used in rendering services.
Accounting for inventory:
The accounting for inventories allows the true and fair picture of financial statements. To calculate COGS, you need to add the beginning inventory with purchases and then reduce the finished good to come at the cost of goods sold for the income statement.
There are four costing methods that allow you to calculate the periodic inventory.
First in, first out:
In this method, the inventory is being calculated based on a first-come and first-serve basis. For calculation purposes, you consider the inventory that comes first in your production systems.
Weighted average cost:
In this method, the inventory is calculated based on the weighted average process. Some of the top financial software widely use this method. It assumes that all the inventory on the system is utilized for production when it comes to inventory calculation.
Net realizable value method:
In the net realizable value method, the estimated selling price less the cost of completion and the costs necessary to make the sale is called the net realizable value method.
Understating inventory:
Whenever we have an understated inventory appearing on the asset side of the balance sheet, the cost of goods sold overstates naturally. Furthermore, the lower volume of inventory in accounting records will reduce the closing stock and increase the Cost Of Goods Sold.
In addition, the understated inventory indicates that there is significantly less inventory that you are holding rather than the actual stock amount. This difference in the inventory proves to be an error with so many other reasons from which it can arise.
A few are given here, and there might be errors in receipt books for stock-taking, or there is a system flow during the movement of raw material from one site to another. Furthermore, there might be chances that there are some unrecorded transactions. There are further chances that there is a loose control of management over the inventory.
Therefore, inventory adjustment is a technique that is required to correct and rectify the overall differences so that you might avoid the understatement and overstatement of your income statement.
Impact of Inventory on the income statement and Balance Sheet:
If the cost of goods sold is overstated, the company’s inventory and net income are understated. Furthermore, when the cost of goods sold is understated, the inventory and the net income of the company are overstated.
This can further be explained in a manner that is acceptable to all. Suppose you have an overstated ending inventory which makes the income statement of the company overstated. And in the next year, when the financial statements are being prepared for the second year, the cost of goods sold will be overstated and understating the profits.
So, there is a massive potential for change in the profits if there is some error in the valuation of the inventories. Hence, auditors need to design comprehensive audit procedures to ensure the accuracy of the account balance. The impact of the error on the valuation of inventory can be summarized as follows.
| Error in Inventory | Cost of Goods Sold | Gross Profit | Net Income |
| Ending Inventory | |||
| Understated | Overstated | Understated | Understated |
| Overstated | Understated | Overstated | Overstated |
| Beginning Inventory | |||
| Understated | Understated | Overstated | Overstated |
| Overstated | Overstated | Understated | Understated |
The Balance sheet effects:
Incorrect inventory balance being reported in the balance sheet at the year-end may cause wrong figures to have appeared when it comes to reporting the values of assets and owner’s equity on the balance sheet of the year.
Furthermore, these types of errors do not affect the overall balance sheet during the accounting period. This is because it is being assumed that the company has accurately determined the inventory balance for the balance sheet for that period.
| Error in Inventory | Assets = | Liabilities + | Owner’s Equity |
| Understated | Understated | No Effect | Understated |
| Overstated | Overstated | No Effect | Overstated |
The cost of inventory:
The cost of an inventory includes some of the most common elements that are elaborated below for your consideration.
- Cost of merchandise
- Discounts
- Duties
- Transportation costs
- Warehousing cost
- Insurance expenses
- Storing cost
Several other costs are being attached to these while making the overall cost of the merchandise ready to be sold to the public. A few of them have been enlisted to make you well aware of what comes in it.
Overall, there is a strong connection between the valuation of inventory and the profit reported by the business. The reporting figure of the inventory is dependent on the quantity owed by the business and the valuation.
The quantity needs to be verified at the end of the period as physical verification is made to ensure the existence and completion of the stock. However, not all stock can be verified due to time limitations and other constraints. So, sampling plays an important role in obtaining audit evidence in this area.
In addition to this valuation is verified by NRV testing and again it’s a sampling that plays an important role in the smooth completion of the audit.
