Impact of inventory

Effects of purchasing and selling inventory

Assets = Liabilities + Equity

The relationship between a business’s resources (assets), its debts or obligations (liabilities), and the ownership interest in the business (equity)

Purchasing inventory

When Jane purchases $500 in inventory from suppliers on credit, it affects the accounting equation in the following manner:

Selling inventory

When Jane sells $758 of her inventory to customers for $1500, the following changes occur:

COGS raw material to finished goods

$500 of finished goods is sold and generates $1,050 in sales (finished goods). The goods are paid for with cash.

If ending inventory is overstated

• Assets are overstated

  • Ending inventory is an asset, but if mistakenly recorded at a higher value, it inflates the overall asset value, leading to over reporting of the business’s assets

• Equity is overstated

  • Overstating assets affects equity directly as assets are a part of the accounting equation.

  • Equity is affected by net income, and COGS affects net income, so a lower COGS value results in an overstatement of equity

• Liabilities remain unaffected

  • Inventory counting errors have no direct impact on the liabilities of the business.

  • Inaccurate inventory records could indirectly affect liabilities if they lead to wrong expense or payable calculations

If ending inventory is understated

• Assets are understated

  • Since ending inventory is an asset, this decreases the overall reported asset value

• Equity is understated

  • Similar to the effect on assets, an understatement of assets directly affects equity

  • With lower asset values, the equity of the business is also decreased

• Liabilities remain unaffected

  • Inventory counting errors generally do not directly impact liabilities.

  • If they result in incorrect calculations of expenses or payable amounts, they could indirectly affect liabilities