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

Another variation of the formula if the cost of goods sold is already provided in the problem and the ending inventory is not given:

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

On the third item above, it is important to know about self-correcting errors, which are errors that self correct in the next period and will not have impact on retained earnings of the current period.

The best example 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 effect 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 impact 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

There could also be errors related to the purchases, these are not typically self-correcting errors. 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: 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. During Year 2, the Company has discovered the following errors in the 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
2. Purchases of $25,000 were incorrectly recorded as $52,000 during Year 1
3. Inventories of $20,000 have been double counted
4. Purchases of $10,000 were not recorded in Year 2

Before working through the table, keep the sign rule in mind: an overstated ending inventory understates COGS and overstates net income (and the reverse for an understatement), while an overstated purchases figure overstates COGS and understates net income (and the reverse for an understatement). The impacts of the above errors on net income for both years and retained earnings at the end of Year 2 are as follows:

	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 1 illustrates the self-correcting pattern from the section above: omitting the $30,000 of in-transit inventory understates Year 1 ending inventory, which overstates Year 1 COGS and understates Year 1 net income by $30,000. That same $30,000 understatement carries into Year 2 as an understated beginning inventory, which understates Year 2 COGS and overstates Year 2 net income by $30,000 - so the two years net to zero impact on retained earnings.

You may use the sample solution above to answer different exam questions such as:

• The errors have net impact of understating Year 1 net income by $57,000 (or overstating cost of goods sold by the same amount)
• The errors have net impact of overstating Year 2 net income by $60,000 (or understating cost of goods sold by the same amount)
• The errors have overstated retained earnings by $3,000 at the end of Year 2.