At the end of Year 1, a company missed counting some units of inventory during a physical count. This resulted in ending inventory being understated for Year 1 by $12,500. Indicate the effects of this error on Year 1, and the following Year 2.
The correct answer and explanation is:
Correct Answer:
Year 1:
- Ending Inventory: Understated by $12,500
- Cost of Goods Sold (COGS): Overstated by $12,500
- Net Income: Understated by $12,500
Year 2:
- Beginning Inventory: Understated by $12,500 (carries forward from Year 1)
- COGS: Understated by $12,500
- Net Income: Overstated by $12,500
Explanation (300 words):
Inventory errors can significantly impact financial statements, particularly the cost of goods sold (COGS) and net income. In this scenario, the company understated ending inventory by $12,500 in Year 1, which led to a chain reaction of effects over two accounting periods.
In Year 1, ending inventory is a component in calculating COGS, using the formula:
COGS = Beginning Inventory + Purchases – Ending Inventory
Because ending inventory was understated, this made COGS appear higher than it actually was by $12,500. A higher COGS directly reduces gross profit and net income, meaning the company’s profit was understated in Year 1.
In Year 2, the understated ending inventory from Year 1 becomes the beginning inventory for Year 2. So, the beginning inventory is also understated by $12,500. This reduces COGS in Year 2, using the same formula above, which in turn increases net income by $12,500.
Importantly, over the two-year period, the total net income is not affected—the understatement in Year 1 is offset by the overstatement in Year 2. However, individual year comparisons or evaluations of performance could be misleading due to these distortions.
This kind of error underscores the importance of accurate inventory counts, especially during year-end physical inventories. Accurate inventory ensures proper financial reporting, performance evaluation, and compliance with accounting standards like GAAP or IFRS.
In summary:
- Year 1: Overstated COGS → Understated Net Income
- Year 2: Understated COGS → Overstated Net Income
- Long term: No effect on total income over the two years, but misleading financial reports.