Effective inventory management gives business owners access to the latest stock-related information, which is useful for financial, auditing, and reporting purposes. To ensure that the current stock system provides accurate metrics, inventory adjustments must be regularly performed.
By keeping inventory records up-to-date, businesses can prevent delays to their operations and save time and money.
What is an Inventory Adjustment?
Inventory adjustment is the process of updating inventory level entries on accounting records to report the difference between what was originally inputted to actual, physical stock.
There are 3 main types of inventory adjustments that businesses will commonly perform.
1. Increase Quantity - The current quantity on hand is higher than what was recorded, which means executives will need to adjust the total value for the item using the current average cost or cost price.
2. Decrease Quantity - The current quantity on hand is lower than what was recorded. The total value for the item must be adjusted.
3. Revaluation - When the quantity on hand is not changed, but executives modify an item's average cost and total value.
Changes to inventory levels can occur for many reasons. For example, when businesses have excess stock products or if they introduce new merchandise into their catalog, they will need to increase their inventory quantity.
On the other hand, customer sales will usually lead to decreases in inventory quantities. Other common reasons for this type of adjustments are-
- Waste - When products, such as technological devices and perishable produce, become obsolete or expire.
- Damage - Goods that are broken or faulty cannot be sold as new products to consumers, therefore, they must be removed or donated.
- Shrinkage - This is a form of inventory loss, in which product levels are low due to theft, shoplifting, administrative errors, or fraud.
- Internal Use - Many brands will use inventory items internally, rather than sell them to customers.
Overstated and Understated Inventory
When making inventory adjustments, management must ensure their stock records are not overstated or understated. The former refers to when there are more inventory items on hand than the stock count. This will typically occur due to product damage, errors in counting, or fraud.
Having overstated inventory records can impact income statements by lowering the cost of goods sold (COGS), which are expenses related to producing or carrying a product. It also causes current assets, retained earnings, and total assets to be overstated.
On the contrary, understated inventory is when there are fewer goods in the store or warehouse than what is inputted in records. These differences will often arise due to poor inventory tracking and accidentally omitting products on store receipts.
When managers record lower inventory levels on their accounting records, this decreases the closing stock and increases the COGS.
Example of an Inventory Adjustment
In the event that an organization experiences overstated or understated inventory records, it must promptly make an inventory adjustment. This will ensure executive teams and employees have accurate information to make decisions, such as demand forecasting and inventory replenishment.
Adjusting inventory requires careful calculations and the COGS formula, which is-
- Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold (COGS)
For example, if a shoewear retailer has accurate inventory counts, in which they have a beginning inventory of $4,000, purchases of $4,000, and an ending inventory of $4,000, the calculations would be-
- $4,000 of Beginning Inventory + $4,000 of Purchases - $4,000 of Ending Inventory = COGS
However, if the retailer's inventory records were overstated and they had $4,500 of ending inventory, instead of $4,000, the calculations would be-
- $4,000 of Beginning Inventory + $4,000 of Purchases - $4,500 of Ending Inventory = COGS
This means the ending inventory was overstated by $500 and managers will need to reduce the cost of goods sold in their financial accounts by $500.
Conversely, if the company's inventory statement was understated and their ending inventory is $3,500, the adjustment calculations would be-
- $4,000 of Beginning Inventory + $4,000 of Purchases - $3,500 of Ending Inventory = COGS
This shows that there is $500 overstated in ending inventory, which means management must increase their cost of goods sold by $500.
Changes to stock levels can occur due to external and unexpected causes, such as miscounting, administrative errors, and inventory loss. In order for businesses to have a robust and effective inventory management system, business teams must account for any discrepancies and modifications to their stock levels.
By implementing proper and diligent inventory adjustment protocols, executives can ensure they have accurate records regarding their products and quantity levels. This will subsequently lead to improved data reporting, informed decision-making, and error-free financial statements.