If Certain Goods Owned By An Entity Were Not Recorded As A Purchase And Were Not Counted In Ending Inventory, In Error, Then What Is The Effect On The Financial Statements? (Assuming This Is A Purchase On Account And The Entity Uses Periodic Inventory System)

If the company or entity did not recorded purchases, then it understated the purchases account in the Income Statement. The ending inventory account is also understated in income statement and on the balance sheet as well. Due to non-recording of certain purchases, accounts payable account is also understated. However, there are no effects on cost of goods sold and net income for the period as both the purchases and ending inventory accounts are understated with the equal amount, so the effect of error on the debit side (purchases is less debited with equal amount) offsets or cancels the effect of error on the credit side (ending inventory is less credited with equal amount) in the calculation of cost of goods sold. As, there is no effect on cost of goods sold, so there is also no effect on net income as the error is not carried out its effect on net income due to offsetting or cancellation.

There is also no effect on Retained Earnings as there is no effect on net income and hence there is also no effect on shareholders’ equity.

Working capital (Current Assets - Current Liabilities) is remained unchanged as the error in inventory (understated) offset the error occurred in accounts payable (understated) by the equal amount.

Current ratio is overstated as the change in current assets and current liabilities affects current ratio. For example, if ending inventory and accounts payable are understated by $10,000 while current assets are $90,000 while current liabilities are $30,000, then before error and after error, the current ratio is shown below:

Before Error

Current Ratio = Current Assets / Current Liabilities = $90,000 / $30,000 = 3:1

After Error

Current Ratio = $80,000 / $20,000 = 4:1

If the company / entity overstated, rather than understated, purchases of certain goods on account / credit and ending inventory in error, then opposite effects are occurred on financial statements.