Effect of Inventory of Assets, Liabilities and Owner’ Equity
Companies can determine the effect of ending inventory errors on the balance sheet by using the basic accounting equation: Assets = Liabilities + Owner’s Equity. How would the over or understatement of inventory impact assets, liability and owner’s equity.
Adjusting the inventory errors will affect the basic accounting equation as follows:
a) Effect of overstatement and understatement on the owners’ equity
Overstated inventory means that less stock was sold over the period (Clever, 2017). It, therefore, reduces the costs of goods sold and increases the gross profit. Increased gross profit translates to increased net profit which is added to the owners’ equity (opening). Overstating the inventory thus also increases the owners’ equity owing from the increased net profits added to the business capital.
Understating inventory will, however, have an opposite effect on the owners’ equity. Reduction in inventory increases the costs of goods sold and reduces the gross profit. Reduced gross profit will reduce the net profit resulting in an understated capital as a lesser figure will be added to the opening capital. It thus follows that understating the inventory leads to an understated owners’ capital.
b) Effect of overstatement and understatement on assets
Inventory forms part of the assets in a firm. Overstating the stock has a direct impact on the assets in that it inflates the asset value.
Wait! inventory impact paper is just an example!
Overstating the inventory is the same as increasing the assets in a firm. On the other hand, understating the stock has a direct relationship to the total assets as it is a part of it. Undervaluing inventory, therefore, leads to understated total assets.
c) Effect of overstatement and understatement on liabilities
The inventories do not affect the liabilities as they are on different sides and parts of the balance sheet (Clever, 2017). The liabilities are what the business owes to the outsiders while the stocks are the goods purchased for purposes of reselling. Overstated inventory is not in any way related to the liabilities, and neither is an understatement in inventories.
Clever, S. (2017). Types of inventory errors and their effects on balance sheet. Retrieved from https://www.accountingtools.com/articles/2017/5/8/types-of-inventory-errors
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