Inventory errors

When there are errors in determining the cost of the inventories, the effect on a single period can be both on the balance sheet and the income statement because of the impacts on ending inventory (balance sheet) and cost of goods sold (income statement), respectively.

When encountering such problems in the CMA exam, you need to remember the formula for cost of goods sold:

Beginning inventory	XX
Add: purchases	XX
Cost of goods available for sale	XX
Less: ending inventory	XX
Cost of goods sold	XX

The inventory errors can be asked in a variety of ways in the CMA exam:

• Its impact on the balance sheet (i.e., ending inventory)
• Its impact on net income of a specific period
• Its impact on retained earnings as at end of the period

Self-correcting errors

When a question asks about the impact on retained earnings, it’s important to know about self-correcting errors, which misstate net income and retained earnings in the period they occur, then reverse in the next period, so retained earnings are correctly stated by the end of that second period.

The best examples of this are inventory count errors that impact the ending inventory value. You also need to remember that the beginning inventory of the current period is the ending inventory of the previous period.

If the ending inventory of the current period is overstated, its effects on the financial statements are as follows:

• Ending inventory is overstated, so current assets and total assets are overstated on the balance sheet at the end of the current period (and understated if ending inventory is understated)
• Cost of goods sold is understated in the current period (see formula for COGS above)
• Net income is overstated the current period

Consequently, if the ending inventory is overstated, it means that the beginning inventory of the next period is also overstated. The impacts of an overstatement of beginning inventory are the complete opposite of the points above:

• Cost of goods sold is overstated in the next period (see formula for COGS above)
• Net income is understated the next period

If this is the only error in the financial statements of the company, the overstatement of net income in period 1 is self-corrected by the understatement of net income in period 2. In effect the net assets are correctly stated at the end of period 2 even though individually, the assets and net income are not correct for each period.

Errors related to purchases

Purchases recorded at the wrong amount, or never recorded, misstate COGS only in the year of the error, so they are not self-correcting and carry into retained earnings. A purchase recorded in the wrong period (a cutoff error) reverses when it is recorded the next year. To avoid confusion, it is recommended to analyze inventory errors by conceptualizing two scenarios:

• What the company actually recorded; and
• What the company should have recorded

The difference between the two scenarios above can normally answer the questions in the exam, especially if you have been provided with the full amounts of purchases.

Other error scenarios

You may also be provided with only the errors and you should be able to determine its impacts on the financial statements. See example below.

Example: Multiple inventory and purchase errors

Achievable uses the periodic inventory system and performs inventory counts at the end of the period to determine cost of goods sold and net income. After the Year 2 year-end count, the company discovered the following errors in its inventory counts and purchases:

1. Inventories of $30,000 were not counted at the end of Year 1 because they were in transit as at the end of Year 1 (shipped FOB shipping point; the purchase was correctly recorded in Year 1)
2. Purchases of $25,000 were incorrectly recorded as $52,000 during Year 1
3. Inventories of $20,000 were double counted in the Year 2 year-end count
4. Purchases of $10,000 were not recorded in Year 2

The table below shows the impact of each error on net income for both years and on retained earnings at the end of Year 2:

	Impact on net income Over(under) statement		Impact on retained earnings, end of Year 2 Over(under) statement
	Year 1	Year 2
1. Inventory understatement Y1	($30,000)	$30,000	—
2. Purchases overstatement ($52,000 - $25,000)	($27,000)	—	($27,000)
3. Inventory overstatement Y2**	—	$20,000	$20,000
4. Purchases understatement	—	$10,000	$10,000
Total impact	($57,000)	$60,000	$3,000

**The Year 2 inventory overstatement of $20,000 will have a self-correcting impact only in Year 3 but have an impact on retained earnings as at the end of Year 2.

Row 2 shows the actual-vs-should-have method described above: Year 1 purchases should have been recorded at $25,000, but the company recorded $52,000, so purchases (and COGS) were overstated by $27,000 and Year 1 net income was understated by $27,000. Because this is a wrong-amount error rather than a cutoff timing error, it doesn’t reverse in Year 2 - the $27,000 understatement of Year 1 net income carries straight into Year 2’s ending retained earnings.