Video Transcript: Inventories and Cost of Goods Sold

Hello and welcome back now we're going to talk about inventories and cost of  goods sold. Inventory is often the largest and most important asset owned by a  merchandising business. The inventory of some companies like car dealerships  or jewelry stores may cost several times more than any other asset the  company owns as an asset, the inventory figure has a direct impact on reporting the solvency of the company and the balance sheet as a factor in determining  cost of goods sold. The Inventory figure has a direct impact on the profitability of the company's operations as reported in the income statement. Thus, the  importance of inventory figures should not be underestimated. A merchandising  company may prepare accurate income statements, statements of retained  earnings and balance sheets only if its inventory is correctly valued on the  income statement. A company, using periodic inventory procedure, takes a  physical inventory to determine the cost of goods sold. Since the cost of goods  sold figure affects the company's net income, it also affects the balance of  retained earnings. On the statement of retained earnings on the balance sheet,  incorrect inventory amounts affect both the reported ending inventory and  retained earnings. Inventories appear on the balance sheet under the heading  current assets, which report reports current assets in a descending order of  liquid liquidity because inventories are consumed or converted into cash within a year or more, or one within a year or one operating cycle, which is whichever is  longer, inventories usually follow cash and receivables on the Balance Sheet.  Recall that under periodic inventory procedure, we determine the cost of goods  sold figure by adding the beginning inventory to the net cost of purchases and  deducting the ending inventory. In each accounting period, the appropriate  expense must be matched with the revenues of that period to determine the net  income apply to inventory. Matching involves determining how much of the cost  of goods available for sale during the period should be deducted from the  current revenues and how much should be allocated to goods on hand, and thus carried forward as an asset in the balance sheet to be matched against future  revenues, because 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 proper value, that it has  properly valued its ending inventory. If the Indian 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 in net income, current assets, total assets and retained earnings. Second, when a company misstate,  misstates its ending inventory in the current year, the company carries forward  that misstatement into the next year. This misstatement occurs because in an 

inventory amount of the current year is the beginning inventory amount of the  next year. And 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  probably stated properly stated. Excuse me to illustrate the overstatement and  understatement. As you can see, in the year 2009 the ending inventory is stated  correctly. Okay? And then it's overstated by $5,000 here, which is going to  reflect a 5000 overstated net income, and then you're going to have an  overstated retained earnings. Based off of the overstated net income, and from  there, it will carry over into 2010 your beginning inventory which was overstated, it will carry over to 40,000 and again by $5,000 everything is overstated or  understated. So that is the importance of making sure that your ending inventory is properly documented. The correctly stated ending inventory for the year 2000  is 35,000 as a result Allen has as a gross margin of 135,000 and a net income of 50,000 the statement of retained earnings shows a beginning retained earnings  of 120,000 and an ending retained earnings of 170,000 when the ending  inventory is overstated by 5000 the gross margin is 140,000 and the net income  is 55,000 the statement of retained earnings then has an ending retained  earnings of 175,000 the ending inventory over statement of $5,000 causes a  $5,000 overstatement of net income and a $5,000 overstatement of retained  earnings. The balance sheet would show both an overstatement of inventory  and an overstatement of retained earnings due to the error in ending inventory,  both the stockholders and creditors may overstate the profitability of the  company. Note that the ending inventory in Exhibit 44 now becomes the  beginning inventory of exhibit 45 however, Allen's inventory at 2010 December  31 is now an accurate inventory of $45,000 as a result, the gross margin in the  income statement with the beginning inventory correctly stated $145,000 and  Allen company has a net income of $91,500 and an ending retained earnings of  $261,500 in the income statement columns at the right in which the beginning  inventory is overstated by 5000 the gross margin is 140,000 and net income is  86,500 with the ending retained earnings also at $261,500 in contrast to an  overstatement ending inventory resulting in an overstatement of net income, an  overstated Beginning Inventory results in an understatement of net income, if  the beginning inventory is overstated, then cost of goods available for sale and  cost of goods sold are also overstated. Consequently, gross margin and net  income are understated. Note, however, that when net income in the second  year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the  understatement of net income in the second year for the two years combined,  the net income is correct at the end of the second year, the balance sheet  contains the correct amounts for both inventory and retained earnings. Exhibit  46 summarizes the effect of errors of inventory valuation. So in your cost of 

goods sold, if your inventory, if your cost of goods sold, the ending inventory is  under, excuse me, let me start that over. I'm sorry. Yes, go ahead. So to  demonstrate your ending inventory and your beginning inventory, the under and  overstatements. If your cost of goods sold is overstated, your ending inventory  will be understated, and then the beginning inventory for the next year would be  understated and then overstated at the end. And same with your net income.