Inventory Errors

now let's see what happens when there's an error in inventory. This is usually when we're talking about an error in the ending inventory when we do the physical count and make an error at that time. Let's check it out. So inventory errors, what we're gonna see is that they correct themselves after two years. If you make an error in the first year and then do everything right in the second year. Well it's gonna self correct after two years but if it's the first year, well that first year is gonna have an overstatement or understatement. Okay. When we think of it by itself. All right. And this overstatement, understatement we're talking about in cost of goods sold which is going to affect our gross profit and our net income. Right? So what I have here is a little summary of what happens if we have an ending inventory notice this is the error right here, ending inventory being overstated. That means that when we counted stuff in the warehouse we made a mistake and we counted too much for whatever reason and the other error would be that ending inventory is understated, write that we miss something when we were counting. Okay. So I think the best way to understand this, although this is a nice little summary. I think the best way to understand an inventory air and how they self correct is with an example. Okay, so the best way to think about this is to think about what would it look like if we hadn't made the air, right? What would have been the totally correct thing to do? And then let's see what happens when we do have an Air. Okay so we're gonna have to two T. Accounts. We're gonna do one T account for the correct inventory and this is inventory. I'll put inventory and then we'll do another T account over here for the incorrect inventory. Okay? So we're gonna do both and we'll see how the how they're going to be different because of the air. So let's go ahead and start on january 1st year one, a company had a balance in inventory of 50,000. Okay so the beginning balance BB in inventory was 50,000. I'm gonna put 50 K. For 50,000 and that's in both situations there was no error made yet. Right? There's gonna be a 50,000 beginning balance and I'm gonna put in year one. Okay, beginning balance of year one is 50,000 during the year purchases of 75,000 were made. So I'm gonna put purchases year 1 75,000. Right? That's gonna increase our inventory when we purchase and there's still no air so these are gonna be okay. Alright so they're gonna follow hand in hand but here it comes on december 31st year one. An error in the inventory count caused a final balance in inventory of 35,000 when the correct amount would have been 30,000. Okay so in the correct amount, what we're saying is that this ending balance of year one, The correct amount would have been 30,000. Right? But for whatever reason they made a mistake and they counted 35,000 worth of goods. Okay, so in that case the ending balance was 35,000. So we're gonna see how this affects our air. The air is gonna come in the cost of goods sold calculation, right? So we counted our ending balance we have are beginning our purchases, we have to back into cost of goods sold, right? Cost of goods sold would be what's coming out of inventory? Right? We would have had some number coming out of inventory to be our cost of goods sold. That gets us to that ending inventory balance. Right. And that's the same thing that would be happening here. This would be the cost of goods sold over here. Okay, so this is just doing a little algebra and finding out what that number would be. So let's figure it out. We had 50,000. Let's do it in the correct inventory. 1st 50,000 plus 75,000 is 100 and 25,000. What number would get us down to 30,000? What we just subtract 30,000 And it's 95,000. Right, so in the correct inventory we should have taken 95,000 in cost of goods sold. Right, because we counted if we had counted correctly, we would have counted 30,000 and goods and backed into a correct amount of cogs of 95,000. So that would have been the correct amount right here, 95,000 in Cogs in year one. But what did happen? What was the incorrect number that came about? So we had 50 plus 75 but instead we had 35,000 ending inventory. Right? So what number would get us to 35,000? And ending inventory? Well, we subtract 35 we see that cost of goods sold would have been 90,000 in this case. Okay, So basically we take our beginning balance plus our purchases and then minus the cost of goods sold, gets us to 35,000. Right? So we're back into that and get 90,000 as the incorrect amount of cost of goods sold. Right? So notice there was an overstatement in ending inventory and look what we have above. There was an if there's an overstatement in ending inventory Then cost of goods sold is understated and that's exactly what we see in our problem. Right. The correct amount would have been 95,000 but we only have 90,000. So there is an understatement there. Okay, so now let's see how this is going to, well, one more thing here. Year one ending inventory, right. We saw was 30,035,000. Was the ending inventory in the incorrect method. So what you're gonna notice is that the ending inventory of year one is going to be the beginning inventory of year two. Right? So let me extend this down here and we'll start beginning balance of year two in this case it's 30,000. But in this case over here it's 35,000. Right? Because that is the ending balance in the previous year when we did it incorrectly. Alright, so now we've got the beginning balance of year two. Let's keep reading the question it tells us. During year two the company purchased 60,000 of inventory. Right? So now we're talking about year two during year two, the company purchased 60,000 of inventory. So these are purchases in year two are gonna be 60,000 and that's the same for both of them. Right? We know how much we purchased, we didn't make an error there. The air was just in last year's inventory count And then finally the year end physical count found the correct balance of 40,000. Alright, so this time they didn't make an error which is generally what you're gonna see in your problems is that they make an error the first year and then not the second year. So that's our ending balance in year two in both cases. Right? So both of them have the correct ending balance there. Now let's find out what cogs is. Right? So now we have our beginning balance, our purchases, what we gotta find cogs, right? Cogs is gonna be right here in year two, it's gonna be what decreased inventory? Right? So what was the cogs? We started with 30,000? We bought another 60,000, but then we were left with 40,000. So if we had 30 plus 60 we had 90,000 of goods available for sale. Right? What we started with plus what we purchased. Well, 40,000 was left at the end of the period. So 50,000 must have been sold, right, 90,000 minus the 40 that was left. That tells us that 50,000 was sold during the period. Okay, Let's do the same thing. On the other side, we had 35,000 plus 60. So notice in this situation on the right hand side are goods available for sale are 95,000, and beginning plus 60 in purchases. And then we say that there's only 40,000 left at the end of the period. Well, that means that 35 plus 60 out of the 95, there's 40 left, meaning we took 55,000 in cost of goods sold. Right. And that's what would get us to the correct ending balance that we counted of 40,000. So what does this tell us in year two, the correct method would have yielded 50,000 of cost of goods sold. And the incorrect method yielded 55,000. Right. And what did we see the year two ending inventory? Well, they're both correct now, right, they're both equal to each other. 80,000. And now let's look at the total costs for both years. Right. When we think of over the span of the two years, how much total cost of goods sold? Did they take? Well in the correct version, they took 145,000. Right, 95 plus 50 that's 100 and 45,000 total cost of goods sold in the two years. And in the other method when we did it incorrectly, 90 plus 55. Well that's also 100 45,000. So notice after two years, just like I told you it's self correct right? We have the same total amount of cogs and the same ending inventory for both. Okay, so an inventory air, it will be corrected after the second year but you can see what happened there right in the first year there was an understatement and an overstatement. And then in the second year it flips right and that's what balances it back out and we end up with the same ending number. Okay, cool. Let's pause here and then let's go ahead and do a practice problem