Inventory Errors and Their Effects – Accounting Impacts and Corrections

Inventory errors are among the most common accounting mistakes and can significantly distort net income, cost of goods sold (COGS), and retained earnings. 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 article examines the types of inventory errors, their effects on financial statements, and how to correct them under U.S. GAAP (ASC 250) and IFRS (IAS 8). Examples and in-text journal entries are included.

1. Common Inventory Errors

Inventory errors typically result from mistakes in:

✦ Counting physical inventory at period-end

✦ Recording purchases or sales in the wrong period

✦ Pricing inventory incorrectly (e.g., cost flow method misuse)

✦ Misclassifying goods in transit or consignment

These errors affect both COGS and ending inventory, which directly impact gross profit and net income.

2. Financial Statement Effects – Year One

Understatement of Ending Inventory

✦ COGS is overstated

✦ Gross profit and net income are understated

✦ Assets and equity are understated

If ending inventory is reported at $45,000 instead of $50,000, the $5,000 understatement inflates COGS and reduces income by $5,000.

Overstatement of Ending Inventory

✦ COGS is understated

✦ Gross profit and net income are overstated

✦ Assets and equity are overstated

Overstating inventory by $8,000 leads to $8,000 less in COGS and $8,000 more in income.

3. Reversal in the Following Year

Inventory errors are self-correcting after two periods:

✦ The beginning inventory of the next period is incorrect

✦ The error in COGS reverses in the next year

✦ Net income is understated one year, then overstated the next (or vice versa)

If ending inventory in Year 1 is understated by $5,000, beginning inventory in Year 2 is also understated by $5,000, lowering COGS and overstating Year 2 income.

4. Income Statement Impact Summary

Type of Error	Year 1 Net Income	Year 2 Net Income	Total Over 2 Years
Ending inventory understated	↓	↑	No change
Ending inventory overstated	↑	↓	No change

Over two periods, the cumulative effect on net income is zero, but the timing of income recognition is distorted.

5. Corrections and Journal Entries

If discovered in a subsequent period and the books are closed, the error is considered a prior period adjustment.

Under U.S. GAAP (ASC 250):

✦ Restate prior period comparative financials

✦ Adjust retained earnings in the earliest period presented

To correct prior overstatement: Dr. Retained Earnings – $8,000 / Cr. Inventory – $8,000.

Under IFRS (IAS 8):

✦ Same guidance as GAAP for material prior-period errors

✦ Restate comparatives and disclose nature of correction

6. Disclosure Requirements

Required disclosures include:

✦ Description of the nature of the error

✦ The impact on each financial statement line item

✦ Amount of correction for current and prior periods

✦ Statement that comparative amounts have been restated, if applicable

These ensure transparency and allow users to understand the correction's implications.