Page 280 - Accounting Principles (A Business Perspective)

This book is licensed under a Creative Commons Attribution 3.0 License

we determine the cost of goods sold by deducting the ending inventory from the cost of goods available for sale, a
highly significant relationship exists: Net income for an accounting period depends directly on the valuation of
ending inventory. This relationship involves three items:

First, a merchandising company must be sure that it has properly valued its ending inventory. If the ending
inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net
income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be
overstated. Thus, any change in the calculation of ending inventory is reflected, dollar for dollar (ignoring any
income tax effects), in net income, current assets, total assets, and retained earnings.
Second, when a company misstates its ending inventory in the current year, the company carries forward that
misstatement into the next year. This misstatement occurs because the ending inventory amount of the current year

is the beginning inventory amount for the next year.
Third, an error in one period's ending inventory automatically causes an error in net income in the opposite
direction in the next period. After two years, however, the error washes out, and assets and retained earnings are
properly stated.
Exhibit 44 and Exhibit 45 prove that net income for an accounting period depends directly on the valuation of
the inventory. Allen Company's income statements and the statements of retained earnings for years 2009 and
2010 show this relationship.
ALLEN COMPANY
For Year Ended 2009 December 31
Ending Inventory
Ending Inventory Overstated
Income Statement Correctly Stated By $5,000
Sales $400,000 $400,000
Cost of goods available for sale $300,000 $300,000
Ending inventory 35,000 40,000
Cost of goods sold 265,000 260,000
Gross margin $135,000 $140,000
Other expenses $85,000 85,000
Net income $ 50,000 $55,000
Statement of Retained Earnings
Beginning retained earnings $120,000 $120,000
Net income 50,000 55,000
Ending retained earnings $170,000 $175,000
Exhibit 44: Effects of an overstated ending inventory
ALLEN COMPANY
For Year Ended 2010 December 31
Beginning
Beginning Inventory
Inventory Overstated
Income Statement Correctly Stated By $5,000
Sales $425,000 $425,000
Beginning inventory $ 35,000 $40,000
Purchases 290,000 290,000
Cost of goods available for sale $325,000 $330,000
Ending inventory 45,000 45,000
Cost of goods sold 280,000 285,000
Gross margin $145,000 $140,000
Other expenses 53,500 53,500
Net income $ 91,500 $ 86,500
Statement of Retained Earnings
Beginning retained earnings $170,000 $175,000
Net income 91,500 86,500
Ending retained earnings $261,500 $261,500
Exhibit 45: Effects of an overstated beginning inventory

Accounting Principles: A Business Perspective 281 A Global Text