Inventory Errors - Online Tutor, Practice Problems & Exam Prep

Inventory errors, particularly in ending inventory, can lead to overstatements or understatements in cost of goods sold (COGS), affecting gross profit and net income. These errors self-correct after two years. For instance, if ending inventory is overstated, COGS is understated, and vice versa. The correct COGS can be calculated using the equation: $(\mathrm{Beginning\; Inventory}+\mathrm{Purchases})-\mathrm{Ending\; Inventory}=\mathrm{COGS}$. Understanding these concepts is crucial for accurate financial reporting.

Inventory Errors

Now let's see what happens when there's an error in inventory. This is usually when we're talking about an error in the ending inventory when we do the physical count and make an error at that time. Let's check it out. So, inventory errors, what we're going to see is that they correct themselves after 2 years. If you make an error in the first year and then do everything right in the second year, well, it's going to self-correct after 2 years. But if it's the first year, well that first year is going to have an overstatement or an understatement, okay? When we think of it by itself, alright? And this overstatement or understatement we're talking about in cost of goods sold, which is going to affect our gross profit and our net income, right?

So, what I have here is a little summary of what happens if we have an ending inventory. Notice this is the error right here. Ending inventory being overstated means that when we counted stuff in the warehouse, we made a mistake and we counted too much for whatever reason, and the other error would be that ending inventory is understated, right? That we missed something when we were counting. Okay? So, I think the best way to understand this, although this is a nice little summary, I think the best way to understand an inventory error and how they self-correct is with an example.

The best way to think about this is to think about what it would look like if we hadn't made the error, right? What would have been the totally correct thing to do and then let's see what happens when we do have an error. Okay? So, we're going to have two T accounts. We're going to do one T account for the correct inventory, and this is inventory. I'll put inventory, and then we'll do another T account over here for the incorrect inventory. Okay? So we're going to do both and we'll see how they're going to be different because of the error. So let's go ahead and start.

On January 1st year 1, a company had a balance in inventory of 50 and that and that's in both situations, there was no error made yet, right? There's going to be a 50,000 beginning balance and I'm going to put in year 1, okay? Beginning balance of year 1 is 50,000. During the year, purchases of 75,000 were made. So I'm going to put purchases year 1, 75,000, right? That's going to increase our inventory when we purchase and there's still no error, so these are going to be okay. Alright? So they're going to follow hand in hand, but here it comes. On December 31st year 1, an error in the inventory count caused a final balance in inventory of 35,000 when the correct amount would have been 30,000, right? So in the correct amount, what we're saying is that this ending balance of year 1, the correct amount would have been 30,000, right? But for whatever reason, they made a mistake and they counted 35,000 worth of goods, okay? So in that case, the ending balance was 35,000. So we're going to see how this affects our error. The error is going to come in the cost of goods sold calculation, right? We counted our ending balance, we have our beginning, our purchases, we have to back into cost of goods sold, right? Cost of goods sold would be what's coming out of inventory, right? We would have had some number coming out of inventory to be our cost of goods sold that gets us to that ending inventory balance, right? And that's the same thing that would be happening here. This would be the cost of goods sold over here. Okay? So this is just doing a little algebra and finding out what that number would be. So, let's figure it out.

We had 50,000, let's do it in the correct inventory first, 50,000 plus 75,000 is a 125,000. What number would get us down to 30,000? Well, we just subtract 30,000 it's 95,000, right? So in the correct inventory, we should have taken 95,000 in cost of goods sold, right? Because we counted if we had counted correctly, we would have counted 30,000 in goods and backed into a correct amount of COGS of 95,000. So that would have been the correct amount right here, 95,000 in COGS in year 1, but what did happen? What was the incorrect number that came about? So we had 50 + 75, but instead we had 35,000 in ending inventory, right? So what number would get us to 35,000 in ending inventory? Well, we subtract 35 and we see that cost of goods sold would have been 90,000 in this case, okay? So basically, we take our beginning balance plus our purchases and then minus the cost of goods sold gets us to 35,000, right? So we can back into that and get 90,000 as the incorrect amount of cost of goods sold, right? So notice, there was an overstatement in ending inventory and look what we have above. If there's an overstatement in ending inventory, then cost of goods sold is understated and that's exactly what we see in our problem, right? The correct amount would have been 95,000, but we only have 90,000 so there is an understatement there. Okay?

partment to better handle such complications.

A company had an ending inventory that was overstated by $5,000 due to a miscount during the year-end inventory count. The amounts reflected in the end of the period balance sheet are:

Alright, let's try this practice. A company had an ending inventory that was overstated by 5,000. Ending inventory was overstated by 5,000 due to a miscount during the year-end inventory count. The amounts reflected in the end-of-period balance sheet are. So, we're going to see if assets are overstated or understated, and equity being overstated, understated, or correct. The first thing we want to think about is it's pretty clear that our assets are going to be overstated, right? Because it told us that the company had ending inventory that was overstated by 5,000. So we know that the ending inventory is an equity account. Now we have to think about equity. The equity accounts, remember, include income, right? Income is included in equity. That's part of our equity. So what's going to happen because of this error is it will affect our cost of goods sold. If we overstate the ending inventory, that means that COGS (Cost of Goods Sold) was understated, right? Because this goes back to the idea of goods available for sale. If we start with our beginning balance in inventory and add to it the purchases during the period, those were our goods available for sale. So when we think about that, the beginning inventory and the purchases, that's everything we have available for sale. It's either going to end up in ending inventory, or it's going to end up in cost of goods sold, right? If we sell it, it goes to cost of goods sold; if we didn’t sell it, it's in ending inventory. So if we say there's more in ending inventory than there should be, that means we're saying there's less in cost of goods sold, right? We took some from the cost of goods sold bucket, and that's going to be understated. So, if cost of goods sold is understated, this is where it's going to be a little tricky. If Cost of Goods Sold is understated, we need to think about income, right? We have revenue minus Cost of Goods Sold, which gives us gross profit. So think about what's happening here. Our cost of goods sold was understated; we said there was less than there actually was, so we said there was less expense than there actually was. That means, if we said there was less expense, that means we took more income, right? We said there was higher income because we understated the expense. So, that means we overstated our income, which means we're going to overstate our equity. So, in this case, we overstated our assets and overstated our equity, right? Because whenever we say we made more income, that's going to increase our equity, so in this case, we increased it too much because COGS was too low. Alright? So, it's a little tricky, right? There's a lot of following the logic and seeing what happens, but you just have to think of it on that high level like that. Let's go ahead and move on to the next question.

A company had a beginning inventory that was understated by $4,000 because the ending inventory in the previous period was understated by $4,000. The amounts reflected in the current end of period balance sheet are:

A company had a beginning inventory that was understated by 4,000 because the ending inventory in the previous period was understated by 4,000. Okay, so last year they made an inventory error. The amounts reflected in the current end of period balance sheet are. So remember, what we have 2 years passed, after 2 years, inventory errors self-correct. Okay? So this is after 2 years, right? Because we made the error last year and then this year passed, so it's been 2 years, so it actually everything is going to self-correct. Our assets are going to be correct, our equity is going to be correct, and if you still don't understand that, go back to the video about the inventory errors and you'll see I did a very specific example where I showed how it corrects after 2 years. Cool? Alright. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What are the effects of inventory errors on financial statements?

Inventory errors, particularly in ending inventory, can significantly impact financial statements. If ending inventory is overstated, the cost of goods sold (COGS) is understated, leading to an overstatement of gross profit and net income. Conversely, if ending inventory is understated, COGS is overstated, resulting in an understatement of gross profit and net income. These errors self-correct after two years, as the incorrect ending inventory of one year becomes the incorrect beginning inventory of the next year. Understanding these effects is crucial for accurate financial reporting and decision-making.

How do inventory errors self-correct over two years?

Inventory errors self-correct over two years because the ending inventory of one year becomes the beginning inventory of the next year. For example, if ending inventory is overstated in Year 1, COGS is understated, inflating net income. In Year 2, the overstated beginning inventory leads to higher COGS, reducing net income. This process balances out the total COGS and net income over the two years. The equation used to calculate COGS is: $(\mathrm{Beginning\; Inventory}+\mathrm{Purchases})-\mathrm{Ending\; Inventory}=\mathrm{COGS}$.

What is the impact of overstated ending inventory on cost of goods sold (COGS)?

When ending inventory is overstated, it means that the inventory count is higher than it should be. This leads to an understatement of the cost of goods sold (COGS). The equation for COGS is: $(\mathrm{Beginning\; Inventory}+\mathrm{Purchases})-\mathrm{Ending\; Inventory}=\mathrm{COGS}$. If ending inventory is overstated, the subtraction results in a lower COGS. This understatement of COGS inflates gross profit and net income, leading to inaccurate financial statements.

How can you identify and correct inventory errors in financial statements?

To identify inventory errors, compare physical inventory counts with recorded amounts. Discrepancies indicate potential errors. Correcting these errors involves adjusting the ending inventory to its accurate value. This adjustment will affect the cost of goods sold (COGS) and, consequently, the gross profit and net income. The equation to calculate COGS is: $(\mathrm{Beginning\; Inventory}+\mathrm{Purchases})-\mathrm{Ending\; Inventory}=\mathrm{COGS}$. Ensuring accurate inventory counts and regular audits can help prevent and correct these errors, leading to more reliable financial statements.

What is the relationship between ending inventory and beginning inventory in the context of inventory errors?

The ending inventory of one year becomes the beginning inventory of the next year. If there is an error in the ending inventory, it carries over to the beginning inventory of the subsequent year. For example, if ending inventory is overstated in Year 1, the beginning inventory in Year 2 will also be overstated. This relationship is crucial because it affects the cost of goods sold (COGS) and net income for both years. The equation for COGS is: $(\mathrm{Beginning\; Inventory}+\mathrm{Purchases})-\mathrm{Ending\; Inventory}=\mathrm{COGS}$.