An understatement of the inventory balance usually causes an understatement in equity and net income, which makes the company appear less profitable. An understated inventory balance increases a company's cost of goods sold as compared to sales, which reduces net income.
An understated inventory balance may make a company look like a bad investment, or vice versa. This may either attract or drive away potential investors based on the wrong information. A company should monitor its inventory count to ensure there is no miscount, which is the main cause of an understated inventory balance. An inventory miscount also affects the next accounting period in reverse as an understated inventory balance becomes overstated. This results in an understated cost of goods sold and total expenses, while net income and equity become overstated.
In some cases, incorrect costing may create an understated inventory balance with the same impact as a quantity miscount. In other cases, employees may steal from a company, reducing the inventory, which has the same effect as an inventory understatement.
A business should implement an inventory tracking system that operates on a consistent schedule to minimize the chances of an inventory understatement. An automated inventory system can simplify the management of inventory by maintaining consistent inventory levels.