Inventory Errors Explained: Definition, Examples, Practice & Video Lessons

These errors affect both COGS and ending inventory, which directly impact gross profit and net income. Since the COGS figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. By correcting the understated ending inventory, the company would provide a more accurate and reliable financial picture to its stakeholders.

Financial Accounting

• Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings.
• Net income for an accounting period depends directly on the valuation of ending inventory.
• The opening inventory on January 1, 2020, would have also been understated, which would have resulted in an understatement of cost of goods sold for 2020.
• ✦ Restate comparatives and disclose nature of correction
• Inventories appear on the balance sheet under the heading “Current Assets,” which reports current assets in a descending order of liquidity.
• The value for cost of the goods available for sale is dependent on accurate beginning and ending inventory numbers.
• On the income statement, the cost of inventory sold is recorded as COGS.

Conversely, understatements of beginning inventory result in understated cost of goods sold and overstated net income. Variations in COGS will have a direct impact on a company’s income statements because the COGS is subtracted from sales to get the gross profit. The chart below identifies the effect that an incorrect inventory balance has on the income statement. 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. Conversely, understatements of ending inventory result in overstated cost of goods sold, understated net income, understated assets, and understated equity. In other words, how would an understatement of ending inventory and purchases impact the current year financial statements?

• If discovered in a subsequent period and the books are closed, the error is considered a prior period adjustment.
• Beg Inventory understated means that the PY is wrong, and RE is understated.
• If both purchases and ending inventory are understated, net income for the period is not impacted because purchases and ending inventory are both understated by the same amount.
• In an active inventory-usage environment, it is common to see an ongoing series of smaller inventory adjustments, which are continually corrected in later periods.
• Example 2 (see Figure 10.23) shows the balance sheet and income statement inventory toggle, in a case when a $1,500 understatement error occurred at the end of year 1.

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. This relationship is crucial because it affects the cost of goods sold (COGS) and net income for both years. The ending inventory of one year becomes the beginning inventory of the next year. Understanding these effects is crucial for accurate financial reporting and decision-making. Understanding these concepts is crucial for accurate financial reporting.

This article examines the types of inventory errors, their effects on financial statements, and how to correct them under U.S. If the company discovers the mistake, it should issue correcting entries and potentially restate prior-period financial statements, depending on the significance of the error. Let’s walk through a numerical example to illustrate the impact of an understated ending inventory on a company’s financial statements.

Proper inventory valuation is important when accounting for inventory through financial reporting. In an active inventory-usage environment, it is common to see an ongoing series of smaller inventory adjustments, which are continually corrected in later periods. Consequently, the error correction in February created a cost of goods sold that was $10,000 lower than normal, which results in net income before taxes that is too high by $10,000. Thus, the inventory error results in a cost of goods sold that is too high by $10,000, which results in net income before tax that is $10,000 too low.

Further assume that the cost of these rotors was $7,000 and that the invoice for the purchase was correctly recorded. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. If net sales are $325,000, the gross profit will be $70,000 ($325,000 – $255,000) instead of $60,000 ($325,000 – $265,000). After subtracting the 2026 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). In 2026, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000).

However, this effect reverses in the following period when beginning inventory is understated, potentially increasing taxable income and resulting in higher tax payments later. Bren Co.'s beginning inventory at January 1, Year 3, was understated by $26,000, and its ending inventory was overstated by $52,000. Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income.

Example of the Impact of an Inventory Error

If there is an error in the ending inventory, it carries over to the beginning inventory of the subsequent year. This adjustment will affect the cost of goods sold (COGS) and, consequently, the gross profit and net income. If ending inventory is overstated, the subtraction results in a lower COGS. This leads to an understatement of the cost of goods sold (COGS). When ending inventory is overstated, it means that the inventory count is higher than it should be.

If the error is never found, then there is an impact in only one accounting period. Net income for an accounting period depends directly on the valuation of ending inventory. On the income statement, the cost of inventory sold is recorded as cost of goods sold. To summarize, inventory errors happen because of the nature of the asset.

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

Example 2 (see Figure 10.23) shows the balance sheet and income statement inventory toggle, in a case when a $1,500 understatement error occurred at the end of year 1. Let’s return to The Spy Who Loves You Company dataset to demonstrate the effects of an inventory error on the company’s balance sheet and income statement. 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. Comparing the two examples with and without the inventory error highlights the significant effect the error had on the net results reported on the balance sheet and income statements for the two years.

Example of Understated Inventory

(In our example, only the balance sheet for December 31, 2025 reported the incorrect amounts of inventory and owner’s equity.) These errors self-correct after two years, as the incorrect ending inventory of one year becomes the incorrect beginning inventory of the next year. On the income statement, the cost of inventory sold is recorded as COGS.

A common error, understatement of inventory, is usually caused by counting inaccuracy during the company’s annual inventory count. The overstatement of inventory in year one caused cost of goods sold to be understated and income overstated in year one. This means there are constant fluctuations in net income caused by inventory errors. Please note that the two accounting periods impacted by an inventory error do not how to easily write a promissory note for a personal loan to family or friends have to be consecutive periods. An inventory error affects two consecutive accounting periods, assuming that the error occurs in the first period and is corrected in the second period. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings.

Thus, over a two-year period, net income would have been understated by $7,000 in 2019 and overstated by $7,000 in 2020. The opening inventory on January 1, 2020, would have also been understated, which would have resulted in an understatement of cost of goods sold for 2020. Let’s look at a few examples to determine the effects of different types of inventory errors. As the ending inventory for one accounting period becomes the opening inventory for the next period, it is easy to see how an inventory error can affect two accounting periods.

On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Although immediate correction of errors is preferable, most inventory errors will correct cash flow statement themselves over a two-year period. However, the 2019 financial statements used for comparative purposes in future years would have to be restated to reflect the correct amounts of inventory and cost of goods sold. However, the allocation of income between the two years was incorrect, and the company’s balance sheet at December 31, 2019, would have been incorrect. If ending inventory is overstated, the cost of goods sold (COGS) is understated, leading to an overstatement of gross profit and net income.

The February ending inventory count is $210,000, rather than the $200,000 that would have been the case if the staff had not found the counting error. At the end of February, the warehouse staff finds the counting error from the preceding month and corrects it. The warehouse staff makes an inventory counting error at the end of January, and does not count several items, resulting in an ending inventory of $150,000 that is $10,000 too low.

If inventory is understated at the end of the year, it means that the amount of inventory being reported is less than the true or correct amount. Correcting these errors involves adjusting the ending inventory to its accurate value. In Year 2, the overstated beginning inventory leads to higher COGS, reducing net income. In Year 2, the beginning inventory would carry over the incorrect ending inventory from Year 1, leading to further implications for COGS calculations.

This discrepancy illustrates how an overstatement in ending inventory results in an understatement of COGS. If the ending inventory is incorrectly counted as \$35,000 instead of the correct amount of \$30,000, the COGS would be calculated differently. Conversely, if ending inventory is understated, COGS is overstated. For instance, if ending inventory is overstated, COGS is understated, and vice versa. ✦ The impact on each financial statement line item ✦ Same guidance as GAAP for material prior-period errors