When inventory errors are made, the effects are manifested in the income statement and on the balance sheets as well. The errors made on one ending inventory balance are carried onto become a misstatement at the starting balance of the next period (Delaney & Whittington, 2010). Inventory errors have an effect on net income in that when there is an overstatement of an ending inventory, there is an understatement of the expense of the cost of goods sold. This overstatement leads to the overstating the gross profit. Net income is overstated by the same amount that gross profit was overstated by. Since the error is propagated forward, the subsequent beginning inventory is understated. This means that the expense of cost of goods sold is overstated and therefore the gross profit is understated. Understating the gross profit has a similar effect of the same magnitude on net income. Essentially, overstating the ending inventory leads to an overstated net income and the opposite holds as well (Porter, 2017).
Inventory errors also have an effect on the balance sheets, but the only advantage or consolation here is that it is not propagated to the next financial period. Counterbalancing accounts for the dissolution of the error. When there is an overstatement of an ending inventory, there is an overstatement of the total assets at the end of the same year which leads to an overstatement of the retained earnings. The counterbalancing that is done in the next financial period gives correct figures and therefore, the effect of the inventory error is only experienced in the same financial period that it was made.
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It has been seen that the effects of inventory errors can lead to overstated profits. If an investor makes the decision based on incorrect figures provided by an auditor, there can be late realizations that can cost the organization huge losses. Such cases are the reason as to why there is an emphasis on having audited financial statements.
Reference
Delaney, P. R., & Whittington, R. (2010). Wiley CPA examination review: Outlines and study guides . Hoboken, N.J: Wiley.
Porter, G. A. (2017). Using financial accounting information: The alternative to debits and credits . Place of publication not identified: Cengage Learning.
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