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.

(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.

How to Prevent an Understated Ending Inventory

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.

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

Inventory errors at the end of a reporting period affect both the income statement and the balance sheet. Ensuring accurate inventory counts and regular audits can help prevent and correct these errors, leading to more reliable financial statements. Inventory errors, particularly in ending inventory, can significantly impact financial statements. Inventory errors can significantly impact financial statements, particularly when they occur in the ending inventory count. Because inventory values affect both the balance sheet and the income statement, an error in one period typically causes an offsetting error in the next.

This will result in an understatement of the cost of goods sold and thus an overstatement of net income. As the ending inventory balance was counted correctly, one may think that this problem was isolated to this year only. At the end of two years, the error would have corrected itself, and the total income reported for those two years would be correct. If net sales for 2025 were $300,000, the gross profit will be incorrectly reported as $75,000 ($300,000 – $225,000) instead of the true amount of $85,000 ($300,000 – $215,000).

• 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.
• The value for cost of the goods available for sale is dependent on accurate beginning and ending inventory numbers.
• 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 COGS.
• Inventories appear on the balance sheet under the heading “Current Assets,” which reports current assets in a descending order of liquidity.

If you overstated beginning inventory, then cost of goods sold is overstated, and gross profit and net income are understated. If you overstated ending inventory, then cost of goods is understated, and gross profit and net income are overstated. When ending inventory (which is not in error) is subtracted from goods available, cost of goods sold is understated by the amount of the understatement in purchases. 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.

Inventory Errors practice set

An “understated ending inventory” in accounting refers to a situation where the value of the ending inventory is reported to be less than its actual value. If you understated beginning inventory, your cost of goods sold will be understated by the error amount. Miscounting inventory doesn’t just have an effect in the period that the balance was miscounted. Whether the inventory understatement is caused by quantity or price issues, the effect on equity is the same — inventory understatement leads to equity understatement. Understated inventory balances will inflate the company’s cost of goods sold relative to sales.

Impacts of Inventory Errors on Financial Statements

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income. Since the cost of goods sold figure affects the company’s net accounting errors and corrections income, it also affects the balance of retained earnings on the statement of retained earnings. 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 evaluating the effect of inventory errors, it is important to have a clear understanding of the nature of the error and its impact on the cost of goods sold formula.

The reason is that an error in the first period changes the ending inventory number, which is used to calculate the cost of goods sold in that period. The overstatement of net income in the first year is offset by the understatement of net income in the second year. Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. Net income is understated because cost of goods sold is overstated. Suppose beginning inventory and purchases were recorded correctly, but ending inventory was incorrect.

When this happens, costs are transferred from the balance sheet to the income statement, so that some of the inventory asset is incorrectly charged to expense. This understatement can arise from various reasons such as errors in counting, valuation mistakes, or even fraudulent activities aimed at manipulating financial statements. Example 1 (shown in Figure 10.22) depicts the balance sheet and income statement toggle when no inventory error is present.

These ensure transparency and allow users to understand the correction’s implications. ✦ Description of the nature of the error ✦ Restate comparatives and disclose nature of correction A new business buys $1 million of merchandise during a year, and records ending inventory of $100,000, which results in a cost of goods sold of $900,000. The reason is that, if costs are not included in inventory, then by default they must have been included in the cost of goods sold.

• The prior period adjustment, dated as of the beginning of year two, is a debit to retained earnings for the after-tax effect of the income overstatement in year one.
• If the ending inventory is incorrectly counted as \$35,000 instead of the correct amount of \$30,000, the COGS would be calculated differently.
• It is also important to consider the effect of the error on subsequent years.
• After subtracting the 2026 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000).
• This adjustment will affect the cost of goods sold (COGS) and, consequently, the gross profit and net income.

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.

Over two periods, the cumulative effect on net income is zero, but the timing of income recognition is distorted. Understated inventory can affect tax payments because it reduces reported net income by overstating the cost of goods sold. There are several causes of understated inventory.

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.

In other words, how would an understatement of ending inventory impact the current year financial statements? In this situation, we have two different errors that state tax and expenditure limits create opposing effects on the income statement and balance sheet. This understatement of COGS inflates gross profit and net income, leading to inaccurate financial statements. Conversely, if ending inventory is understated, COGS is overstated, resulting in an understatement of gross profit and net income. If you understated ending inventory, your cost of goods sold will be overstated by the error amount, and net income and gross profit are understated.

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?

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.