Definition of Inventory Error
An inventory error could be the result of any of the following:
- Omitting some items when physically counting inventory
- Double counting some items during a physical inventory
- Clerical errors when adding/multiplying inventory details
Since the ending inventory of one accounting period will automatically become the beginning inventory for the next accounting period, the calculation of the cost of goods sold for both accounting periods will be incorrect. Of course this means that the company's gross profit, operating income, and net income for both periods will also be incorrect.
Example of an Inventory Error
Assume that a company began operations on December 1. During December the company purchased $100,000 of goods that it planned to sell to customers. The company's December 31 ending inventory was calculated to be $15,000. As a result, its balance sheet will report inventory of $15,000 and its income statement will report cost of goods sold of $85,000 ($100,000 - $15,000). During January the company purchased $130,000 of goods and had $20,000 in inventory at the end of January 31. Therefore, January's cost of goods sold will be $125,000 (beginning inventory of $15,000 plus purchases of $130,000 minus ending inventory of $20,000).
Now let's assume that only one error occurred and it involved the calculation of the December 31 ending inventory. Instead of the $15,000 which was reported, the true amount of inventory was $19,000. That meant the December 31 balance sheet understated the true cost of inventory by $4,000. It also meant that December's income statement cost of goods sold was not the reported $85,000. Rather, the true cost of goods sold was $81,000 ($100,000 minus $19,000 of inventory). In January, the true cost of goods sold is $129,000 (beginning inventory of $19,000 plus the purchases of $130,000 minus the January 31 inventory of $20,000) not the $125,000 that had been reported.