From my FAR lesson on inventory errors.
Short answer: if ending inventory is understated, cost of goods sold is overstated, so gross profit, net income and retained earnings are all understated. Inventory (a current asset) is understated too. Flip every one of those for an overstatement. The error reverses itself in the next year, as long as that year’s ending count is right.
Why one number moves everything
In a periodic system, cost of goods sold is a plug:
Beginning inventory + Purchases – Ending inventory = Cost of goods sold
Ending inventory is subtracted. So if you count too little at year end, you subtract too little, and COGS comes out too high. Everything below COGS on the income statement follows it, and net income closes into retained earnings.
Worked example
A company’s correct ending inventory for Year 1 is $50,000, but the count misses a section of the warehouse and records $40,000. Ignore income taxes for now.
| Item | Year 1 effect | Year 2 effect (if Year 2 ending inventory is counted correctly) |
|---|---|---|
| Ending inventory | Understated $10,000 | Correct |
| Beginning inventory | Correct | Understated $10,000 |
| Cost of goods sold | Overstated $10,000 | Understated $10,000 |
| Net income | Understated $10,000 | Overstated $10,000 |
| Retained earnings (end of year) | Understated $10,000 | Correct |
| Total assets (end of year) | Understated $10,000 | Correct |
That is the counterbalancing effect: Year 1’s ending inventory becomes Year 2’s beginning inventory, so the same $10,000 pushes Year 2’s COGS the other way. Net income is wrong in both years, but the two errors cancel in retained earnings by the end of Year 2.
The correcting entry
If the error is found in Year 2, before the Year 2 books are closed, it is corrected as a prior period adjustment to beginning retained earnings (ignoring taxes):
| Account | Debit | Credit |
|---|---|---|
| Inventory (beginning) | 10,000 | |
| Retained earnings | 10,000 |
With a 21% tax rate, the after-tax effect on net income and retained earnings is $7,900, and the other $2,100 goes to income taxes payable (assuming the same error flowed into the Year 1 tax return). If the error is found after Year 2 is closed, no entry is needed because the error has already counterbalanced, though the comparative statements are still restated.
Watch the video
Here is the clip from the lesson where I walk through the chain:
Common traps on the exam
- Mixing up the direction. Ending inventory and net income move together. Ending inventory and COGS move opposite.
- Forgetting Year 2. A question that asks about Year 2 net income wants the reversal, not “no effect”.
- Retained earnings after two years. If Year 2 ending inventory was counted correctly, retained earnings at the end of Year 2 is correct.
- Purchases errors are different. Goods received but not recorded as a purchase and not counted can leave net income unaffected, because the two misses offset. Inventory and accounts payable are still both understated on the balance sheet.
FAQ
Does understated ending inventory overstate or understate net income? Understate. COGS is too high, so income is too low.
Is an inventory error self-correcting? Yes, over two periods, as long as the next year’s ending count is right. Net income is still misstated in each of those years.
What happens to working capital? Inventory is a current asset, so understated ending inventory understates current assets and working capital.
Studying for FAR? I teach these topics as Lead Instructor at Copernicus CPA Review, where you can watch the full lessons.
Want one-on-one help with a section that keeps tripping you up? Book a tutoring session with me.
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