Friday, 21 September 2012

Inventory assessment error and Cash flow statement

           We know that decrease in inventory has to be added to the net income to arrive at the cash flow statement using indirect method.

           Inventory assessment errors affect

1.  Change in inventory under periodic method. This is because, under this method, the estimation error can happen while estimating the ending inventory at the end of the year. Beginning inventory can also have the error because of the faulty estimation of ending inventory in the previous year.

2.   COGS directly under perpetual system. Here whenever the sales happens, COGS is estimated for the corresponding sales and is subtracted from the merchandise inventory to arrive at the endong inventory.

Either ways the error in calculation of the inventory will always cancel out when the decrease in inventory is added to the net income figure. This is because the error in inventory causes the same error in the non cash expense of the COGS, in the net income figure . When we add  the decrease in inventory, we actually cancel the non cash COGS in the net income figure along with the error.For further details see the earlier blog on the indirect method of preparing the cashflow from operations.