The ending inventory, or the cost of merchandise on hand at the end of an accounting period, has an impact on the current period's financial statements. On the income statement, ending inventory is a deduction in the calculation of the cost of goods sold, and therefore has an indirect (negative) relationship with it. If the ending inventory is understated, the cost of goods sold will be overstated, and vice versa. This, in turn, affects the gross profit, which is calculated as net sales minus the cost of goods sold. If the ending inventory is understated, the gross profit will be understated, and vice versa. Net income, which is calculated as gross profit minus operating expenses, is also affected by the ending inventory in the same way as gross profit.
On the balance sheet, ending inventory is part of current assets and therefore has a direct (positive) relationship with them. If the ending inventory is understated, the total current assets will be understated, and vice versa. However, ending inventory has no effect on liabilities. It does have an effect on owners' equity, which is calculated as the net income of the period transferred to the owners' equity account at the end of the period. If the ending inventory is understated, the owners' equity will be understated, and vice versa.
The beginning inventory, or the inventory balance carried over from the previous period, also has an impact on the current period's financial statements. On the income statement, beginning inventory is an addition in the calculation of the cost of goods sold, and therefore has a direct relationship with it. If the beginning inventory is understated, the cost of goods sold will be understated, and vice versa. This, in turn, affects the gross profit, which has an indirect (negative) relationship with the beginning inventory. If the beginning inventory is understated, the gross profit will be overstated, and vice versa. Net income is also affected by the beginning inventory in the same way as gross profit.
On the balance sheet, beginning inventory has no effect on current assets, as only the ending inventory is included in this category. However, it does have an effect on owners' equity, which is calculated as the net income of the period transferred to the owners' equity account at the end of the period. If the beginning inventory is understated in the current period, it will have an indirect effect on the ending owners' equity, as the understated beginning inventory will result in an overstated net income, which will be transferred to the owners' equity account.
The ending inventory of the current period becomes the beginning inventory of the following period, and therefore has an impact on the following period's financial statements. On the income statement, the beginning inventory has a direct effect on the cost of goods sold and an indirect (negative) effect on gross profit and net income. On the balance sheet, the beginning inventory is included in current assets and has a direct effect on them. It also has an indirect effect on owners' equity through its impact on net income. It is important for businesses to accurately track and value their inventories to ensure the accuracy of their financial statements.
