Inventory Errors and Financial Statements

Income statement effects. 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. Left unchanged, the error has the opposite effect on cost of goods sold, gross profit, and net income in the following accounting period because the first accounting period's ending inventory is the second period's beginning inventory. The total cost of goods sold, gross profit, and net income for the two periods will be correct, but the allocation of these amounts between periods will be incorrect. 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. The chart below identifies the effect that an incorrect inventory balance has on the income statement.


 
 |  | Impact of Error on
| Error in Inventory | Cost of Goods Sold | Gross Profit | Net Income
| Ending Inventory |  |  | 
|   Understated | Overstated | Understated | Understated
|   Overstated | Understated | Overstated | Overstated
| Beginning Inventory |  |  | 
|   Understated | Understated | Overstated | Overstated
|   Overstated | Overstated | Understated | Understated

Balance sheet effects. An incorrect inventory balance causes the reported value of assets and owner's equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period. 


 |  | Impact of Error on
| Error in Inventory | Assets = | Liabilities + | Owner's Equity
| Understated | Understated | No Effect | Understated
| Overstated | Overstated | No Effect | Overstated

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