What Is the Effect of an Unrecorded Purchase and Understated Ending Inventory on Financial Statements?
Introduction
Errors in recording purchases and ending inventory can affect a company's financial statements, including its balance sheet, income statement, and financial ratios. However, the effect of an accounting error depends on how the error affects the related accounts.
Suppose a company purchases goods on credit but accidentally fails to record the purchase and does not include those goods in its ending inventory. What happens to purchases, cost of goods sold, net income, accounts payable, retained earnings, working capital, and the current ratio?
In this article, we will explain the effects of this accounting error under the periodic inventory system, using a practical example and simple calculations.
What Happens When a Purchase Is Not Recorded?
When an entity purchases goods on credit, it normally records the transaction as follows:
Debit: Purchases Account
Credit: Accounts Payable Account
Under a periodic inventory system, purchases are recorded throughout the accounting period, while the cost of goods sold is calculated at the end of the period using beginning inventory, net purchases, and ending inventory.
If a credit purchase is omitted from the accounting records and the goods are also excluded from ending inventory, the following accounts are understated:
Purchases
Ending inventory
Accounts payable
Assuming the omitted purchase and the inventory error are equal in amount, some effects cancel each other out, while others remain.
Effects on the Financial Statements
1. Effect on Purchases
Purchases are understated because the company has failed to record the goods purchased during the accounting period.
For example, if a company purchases goods worth $10,000 on credit but does not record the transaction, the Purchases Account will be understated by $10,000.
Under the periodic inventory system, this error affects the calculation of the cost of goods sold.
2. Effect on Ending Inventory
Ending inventory is also understated because the company has failed to include the purchased goods in its year-end inventory count.
For example, if the actual ending inventory is $50,000 and goods worth $10,000 are omitted, the reported ending inventory will be:
Actual ending inventory = $50,000
Less: Unrecorded goods = $10,000
Reported ending inventory = $40,000
As a result, inventory reported on the balance sheet will be understated by $10,000.
3. Effect on Cost of Goods Sold
Under the periodic inventory system, cost of goods sold is calculated as follows:
Cost of Goods Sold = Beginning Inventory + Net Purchases − Ending Inventory
When purchases and ending inventory are both understated by the same amount, their effects on the cost of goods sold offset each other.
Consider the following example:
| Particulars | Correct Amount | Incorrect Amount |
|---|---|---|
| Beginning inventory | $20,000 | $20,000 |
| Net purchases | $80,000 | $70,000 |
| Goods available for sale | $100,000 | $90,000 |
| Less: Ending inventory | $30,000 | $20,000 |
| Cost of goods sold | $70,000 | $70,000 |
The incorrect purchases figure reduces goods available for sale by $10,000. However, the understated ending inventory also reduces the amount deducted from goods available for sale by $10,000.
Consequently, the cost of goods sold remains unchanged.
Conclusion: There is no effect on cost of goods sold when purchases and ending inventory are understated by equal amounts under these assumptions.
4. Effect on Net Income
Net income is calculated by deducting expenses from revenue.
Because the error does not change the cost of goods sold, it does not change gross profit or net income, assuming all other items remain unchanged.
For example, if sales revenue is $100,000 and the correct cost of goods sold is $70,000, gross profit is $30,000.
Even though the company incorrectly reports purchases and ending inventory, the cost of goods sold remains $70,000. Therefore, gross profit remains $30,000.
Conclusion: Net income remains unchanged because the two errors offset each other in the calculation of cost of goods sold.
5. Effect on Accounts Payable
Accounts payable is understated because the company has not recorded the credit purchase.
For example, if the company has correctly recorded accounts payable of $30,000 before considering the omitted purchase, the reported amount will be $30,000 rather than the correct $40,000.
This means the company reports fewer current liabilities than it actually owes.
Conclusion: Accounts payable is understated by the amount of the unrecorded credit purchase.
6. Effect on Retained Earnings and Shareholders' Equity
Retained earnings generally increase when a company earns a profit and decrease when it incurs a loss or distributes dividends.
In this example, net income remains unchanged because the errors in purchases and ending inventory offset each other. Therefore, retained earnings are not affected by this error.
Assuming there are no other changes, total shareholders' equity also remains unchanged.
However, the balance sheet still contains errors because inventory and accounts payable are both understated.
Effect on Working Capital
Working capital measures the difference between current assets and current liabilities.
The formula is:
Working Capital = Current Assets − Current Liabilities
When ending inventory and accounts payable are understated by the same amount, current assets and current liabilities both decrease equally.
For example, assume that inventory and accounts payable are each understated by $10,000.
| Particulars | Correct Amount | Incorrect Amount |
|---|---|---|
| Current assets | $90,000 | $80,000 |
| Current liabilities | $30,000 | $20,000 |
| Working capital | $60,000 | $60,000 |
Correct working capital:
$90,000 − $30,000 = $60,000
Incorrect working capital:
$80,000 − $20,000 = $60,000
Therefore, working capital remains unchanged.
Although the company reports incorrect amounts for current assets and current liabilities, the difference between them remains the same.
Effect on the Current Ratio
The current ratio measures a company's ability to meet its short-term obligations using its current assets.
The formula is:
Current Ratio = Current Assets ÷ Current Liabilities
Using the same example, the correct and incorrect current ratios are calculated below.
Before the Error
Current assets = $90,000
Current liabilities = $30,000
Current ratio = $90,000 ÷ $30,000 = 3:1
After the Error
Current assets = $80,000
Current liabilities = $20,000
Current ratio = $80,000 ÷ $20,000 = 4:1
| Particulars | Before Error | After Error |
|---|---|---|
| Current assets | $90,000 | $80,000 |
| Current liabilities | $30,000 | $20,000 |
| Working capital | $60,000 | $60,000 |
| Current ratio | 3:1 | 4:1 |
Conclusion: The current ratio is overstated, increasing from 3:1 to 4:1 in this example.
The reason is that the same $10,000 reduction has a proportionally greater effect on current liabilities than on current assets. The current ratio therefore increases even though working capital remains unchanged.
This illustrates why financial ratios should be interpreted carefully. An accounting error can make a company's short-term liquidity appear stronger than it actually is.
What If Purchases and Ending Inventory Are Overstated?
If a company overstates credit purchases and ending inventory by the same amount, the effects are generally the opposite of those described above.
Assuming the same amount is involved in both errors:
Purchases: Overstated.
Ending inventory: Overstated.
Accounts payable: Overstated.
Cost of goods sold: No effect, because the two errors offset each other.
Net income: No effect.
Retained earnings: No effect.
Shareholders' equity: No effect, assuming no other changes.
Working capital: No effect, because current assets and current liabilities increase equally.
Current ratio: Understated in the usual case, because current assets and current liabilities both increase by the same amount.
For example, if current assets are $90,000 and current liabilities are $30,000 before the error, the current ratio is 3:1.
If both inventory and accounts payable are overstated by $10,000, current assets become $100,000 and current liabilities become $40,000.
The incorrect current ratio becomes:
$100,000 ÷ $40,000 = 2.5:1
The ratio decreases from 3:1 to 2.5:1, even though working capital remains $60,000.
Summary of the Effects
| Financial statement item | Effect of an omitted credit purchase and understated ending inventory |
|---|---|
| Purchases | Understated |
| Ending inventory | Understated |
| Cost of goods sold | No effect |
| Net income | No effect |
| Accounts payable | Understated |
| Retained earnings | No effect |
| Shareholders' equity | No effect |
| Working capital | No effect |
| Current ratio | Overstated in the example |
Final Thoughts
When goods purchased on credit are not recorded as purchases and are also omitted from ending inventory under a periodic inventory system, the accounting error has several important effects.
Purchases, ending inventory, and accounts payable are understated. However, cost of goods sold and net income remain unchanged because the equal errors in purchases and ending inventory offset each other.
Retained earnings, shareholders' equity, and working capital also remain unchanged under the stated assumptions. The current ratio, however, is overstated in the numerical example because current assets and current liabilities decrease by the same amount but at different proportions.
The key lesson is that an unchanged net income or working capital figure does not necessarily mean the financial statements are correct. Companies must record purchases accurately, count inventory properly, and reconcile supplier balances to present reliable financial information.
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