Inventory errors can result from a counting mistake or incorrect costing of inventory items. The ending inventory balance could be overstated or understated as a result of these errors, which has an effect on the cost of goods sold and net income calculations. Inventory errors are usually two-period errors, because the ending inventory of one period is the beginning inventory of the next. To fix inventory errors, reverse the error as soon as it detected, record the correct accounting entries and restate prior-period financial statements.
Determine the impact of the inventory error. According to the Cliffs Notes website, ending inventory overstatement or beginning inventory understatement leads to cost of goods sold understatement and net income overstatement, while ending inventory understatement or beginning inventory overstatement leads to cost of goods sold overstatement and net income understatement. Cost of goods sold and net income are income statement accounts. Net income is a company’s bottom line -- it is the result after cost of goods sold, operating expenses, interest and taxes are deducted from sales. The inventory and retained earnings accounts on the balance sheet are affected for the period in which the error occurs. The retained earnings account is affected because a period’s net income, less dividend payments, is added to the period’s beginning retained earnings balance to get an ending balance.
Reverse the error and record the correct journal entries if an inventory error is detected in the same period. For example, if you incorrectly record a cash inventory purchase as $10,000 instead of $1,000, debit or increase cash and credit or decrease inventory by $9,000 ($10,000 - $1,000) each to reverse the error.
Correct a prior-period inventory error. For example, if the previous year's ending inventory was understated by $1 million, then the beginning inventory and retained earnings balances for the current year also are understated by $1 million. Debit or increase inventory and credit or increase retained earnings by $1 million each to reverse the prior-period error. If you count the inventory correctly this year, there should be no inventory-related errors on your financial statements for this year and going forward.
Restate prior-period financial statements. The cost of goods sold and net income accounts on the income statement and the inventory and retained earnings accounts on the balance sheet may need to be changed. Continuing with the example, add $1 million each to the inventory and retained earnings accounts on the prior-period balance sheet, subtract $1 million from the cost of goods sold amount on the prior-period income statement, and add $1 million to the net income on the prior-period income statement.
Write disclosure notes describing the nature and impact of the inventory error. Write one disclosure note for the current period to describe the correction to the beginning inventory and beginning retained earnings balances. Write a second disclosure note describing the changes to the prior-period's financial statements.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.