BUS103: Introduction to Financial Accounting

Measurement error leads to systematic errors in replenishment and inaccurate financial statements.

LEARNING OBJECTIVES

Explain how a measurement error affects a company's inventory value

KEY TAKEAWAYS

Key Points

• In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.
• Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory). Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements.
• Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.
• An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income.

Key Terms

• phantom inventory: Phantom inventory is a common expression for goods that an inventory accounting system considers to be on-hand at a storage location, but are not actually available. This could be due to the items being moved without recording the change in the inventory accounting system, breakage, theft data entry errors or deliberate fraud. The resulting discrepancy between the online inventory balance and physical availability can delay automated reordering and lead to out-of-stock incidents. If not addressed, phantom inventory can also result in broader accounting issues and restatements.

Measurement Error Impacts

Measurement error is the difference between the true value of a quantity and the value obtained by measurement. The two main types of error are random errors and systematic errors. In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.

Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) when the actual inventory is lower than the measurement or understatements (missing inventory) when the actual stocks are higher than the measurement. Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements. It is quite easy to overlook goods on hand, count goods twice, or simply make mathematical mistakes.

Physical inventory: Female clerk doing inventory work using a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand

Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.

Inventory controlling helps revenue and expenses be recognized. As a result, an incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. A general rule is that overstatements of ending inventory cause overstatements of income, while understatements of ending inventory cause understatements of income. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct. It is also vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible.