Effect of Inventory Errors

Inventory errors can occur for a variety of reasons and impact both the income statement and the balance sheet of the business.

Reasons for Inventory Errors

There are many reasons for and types of inventory errors including the following:

• Physical inventory was miscounted
• Costs were incorrectly assigned to inventory
• Incorrect identification of inventory items
• Inventory in transit not dealt with incorrectly
• Consignment inventory incorrectly dealt with
• Incorrect cut-off procedures followed during the inventory count

Inventory Errors Example

Suppose a new business starts with zero beginning inventory and makes purchases of 8,000 during year 1. An inventory count at the end of the year indicates that the ending inventory is 5,000. During year 2, the business makes further purchases of 6,000, and the inventory count at the end of year 2 shows an ending inventory of 4,000.

The calculation of cost of sales for each year is summarized in the following table.

Suppose now that the inventory count at the end of year 1 was incorrectly recorded as 5,800 instead of the correct amount of 5,000. The recalculation of cost of sales including the inventory error is now summarized as follows:

The overstatement of the ending inventory of 800 (5,800-5,000), resulted in the cost of sales being understated by 800 (3,000-2,200), and therefore the net income of the business being overstated by 800.

Inventory Errors Affect Two Accounting Periods

The ending inventory of an accounting period will always become the beginning inventory of the following accounting period. For this reason inventory errors will always affect two accounting periods.

It can be seen from the tables above that the overstatement of the ending inventory of year 1 becomes an overstatement of the beginning inventory of year 2. As a result of this, the cost of sales (COS) for year 2 is overstated by 800 (7,800-7,000), and the net income for year 2 is therefore understated by 800.

It is important to understand that when the two periods are combined the inventory errors have no effect as the same error which resulted in an understatement in cost of sales in year 1 also results in an overstatement in cost of sales in year 2. This is summarized in the table below.

In each case, the combined cost of sales for the two years is the same at 10,000 and the effect on net income is zero.

Effect on Operating Cash Flow

As the starting point in the calculation of operating cash flow is net income, it may seem odd that the operating cash flow of the business is not impacted by inventory errors.

In the above example, for year 1, the overstatement of inventory resulted in an overstatement of net income of 800, which should in turn result in an overstatement of the operating cash flow by a similar amount.

However, the error also resulted in an overstatement of the balance sheet ending inventory, this in turn caused the inventory movement for the period to be overstated. Since this movement forms part of the working capital movement used in the calculation of operating cash flow, it compensates for the effect of the change in net income, resulting in no change in the operating cash flow itself.

Summary of Effects of Inventory Errors on Net Income

The impact on net income of an inventory error depends on whether the error is in the beginning or ending inventory. The effects are summarized in the table below.

It should be noted that the impact on net income is always in the opposite direction to the error in beginning inventory, and is always in the same direction as the error in ending inventory.