Inventory Errors: How a Count Changes Two Years of Income

An inventory error is a mistake in the count or cost of ending inventory. If purchases are recorded correctly, understated ending inventory overstates cost of goods sold (COGS) and understates net income. Overstated inventory does the reverse. Ending inventory becomes next year’s beginning inventory, so a correct count next year reverses the income error. These are called counterbalancing (self-correcting) errors.

A retailer can appear to have improved its profit margin simply because someone missed a shelf last December. To judge performance, a manager needs to know which year earned the profit. This lesson uses a periodic inventory system, which determines COGS at period-end. Assume other amounts are correct and ignore income taxes.

Watch the inventory error walkthrough

At 1:40, Professor Farhat introduces overstated and understated counts. Listen for which inventory balance enters the formula with a minus sign.

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How do inventory errors affect cost of goods sold?

Beginning inventory + net purchases + freight-in − ending inventory = cost of goods sold. Net purchases means purchases less purchase returns, allowances, and discounts. Freight-in is the shipping cost to bring purchased goods in and is added separately. Beginning inventory, net purchases, and freight-in together give the cost of goods available for sale. The worked examples below assume no freight-in. The physical count tells you how much cost belongs to merchandise still on hand.

Imagine moving a $100 carton from the sold pile to the unsold pile on paper. Available cost stays the same. The inventory asset rises by $100 and the expense falls by $100. Sales revenue stays the same, so gross profit (net sales less COGS) rises by $100. With all other expenses fixed, income rises by the same amount.

What causes inventory errors?

Most inventory errors come from the year-end count or from deciding who owns the goods. Common causes include:

• Missing a shelf, aisle, or storage location during the count
• Counting the same items twice
• Recording goods in transit with the wrong company. Under FOB shipping point, the buyer owns goods once they ship. Under FOB destination, the seller owns them until they arrive.
• Counting consigned goods incorrectly. Goods a store holds for another company (the consignor) belong to the consignor, so they stay out of the store’s count. Goods a company has sent out on consignment still belong to it.
• Pricing mistakes, such as using the wrong unit cost or multiplying quantity by cost incorrectly

Auditors observe the physical count to help catch these problems. The count supports the existence and completeness audit assertions.

Goods in transit and consignment mistakes often affect purchases too. When they do, use the purchase cutoff errors lesson instead.

How does one missed shelf change two years of income?

In this hypothetical example, Cedar Trail Outfitters overlooks 24 camp stoves that cost $100 each. Its Year 1 ending inventory should be $18,000. The count shows $15,600. The supplier invoices were recorded correctly, and the company sells goods for $92,000 during Year 1.

The $2,400 shelf cost belongs on the balance sheet. The missed shelf charges it to Year 1 earnings instead. If operating expenses are $26,000, correct income is $12,000. Reported income is $9,600. The retailer collected and paid exactly the same cash under both calculations.

Now assume the error carries forward, Year 2 net purchases are $67,000, and the correct Year 2 count is $20,000. Correct Year 2 COGS is $18,000 + $67,000 − $20,000 = $65,000. Using the opening balance carried from the books gives $15,600 + $67,000 − $20,000 = $62,600. This time the mistaken amount enters the formula with a plus sign.

Suppose correct Year 2 income is $15,000. The books show $17,400. Across both years, correct income totals $27,000 ($12,000 + $15,000), and reported income also totals $27,000 ($9,600 + $17,400). Yet the reported increase between years is $7,800. Actual improvement was only $3,000.

What if the count is too high instead?

Flip the example. Suppose Cedar Trail counts the stove shelf twice, so Year 1 ending inventory shows $20,400 instead of $18,000. Year 1 COGS drops to $51,600 ($72,000 − $20,400), and reported income rises to $14,400.

In Year 2, the $20,400 opening balance pushes COGS up to $67,400 ($20,400 + $67,000 − $20,000), so reported income falls to $12,600. The two-year total is still $27,000. But now the books show income dropping by $1,800 when it actually rose by $3,000.

Two-year summary of ending inventory errors

This table assumes purchases are recorded correctly, the Year 2 count is correct, and no correcting entry is made. OpenStax’s Principles of Accounting walks through the same two-year pattern if you want a second example.

How do inventory errors affect the balance sheet?

At the first year-end, Cedar Trail understates inventory and total current assets by $2,400. It also understates retained earnings by $2,400 because less reported income flows into equity. Accounts payable is correct because the supplier invoice was recorded. Working capital (current assets less current liabilities) is therefore understated by $2,400, and the current ratio (current assets divided by current liabilities) is understated too.

At the second year-end, the correct count restores the inventory asset. The equal and opposite income errors also restore cumulative retained earnings, assuming dividends were recorded correctly. A correct ending equity balance can therefore coexist with two misleading annual profit figures. The University of Connecticut’s inventory error lesson also traces this two-year relationship.

A common mistake is to apply this result whenever a question mentions missing goods. Check what happened to the invoice. If the same goods were omitted from purchases, use the companion lesson on purchase cutoff errors and the current ratio.

How do you correct an inventory error?

The fix depends on when the error is found. Cedar Trail’s missed shelf shows both cases. Assume the Year 1 financial statements have already been issued and the error is material. Income taxes are still ignored here.

Found in Year 2, before the books are closed

Year 1 income was understated by $2,400, and that understated income has already been closed into retained earnings. Under the periodic system, the inventory account still shows the $15,600 opening balance. One entry fixes both:

Because the credit goes straight to retained earnings, this is a prior period adjustment, not Year 2 income. With the opening balance corrected to $18,000, Year 2 COGS comes out at the correct $65,000.

Found after Year 2 is closed

By then the error has counterbalanced. Inventory is correct at $20,000 and cumulative retained earnings are correct, so no journal entry is needed. However, if the error is material, each affected prior year presented for comparison must be restated under ASC 250. If both Year 1 and Year 2 are presented, both years’ misstated results must be corrected, even though cumulative retained earnings are correct. ASC 250 is the FASB standard on accounting changes and error corrections.

What if the question includes income taxes?

Multiply the pretax error by (1 minus the tax rate) to get the net income effect. With an assumed 25% tax rate, Cedar Trail’s $2,400 count error would understate Year 1 net income by $1,800 ($2,400 × 0.75) and overstate Year 2 net income by the same $1,800.

Key takeaways

• Understated ending inventory overstates COGS and understates net income, inventory, retained earnings, working capital, and the current ratio.
• Overstated ending inventory does the opposite.
• Year 1’s ending inventory is Year 2’s beginning inventory, so a correct Year 2 count reverses the income error. That’s why inventory errors are called counterbalancing.
• After two years, total income and retained earnings are correct, but each year’s income, and the trend between years, is wrong.
• For a material Year 1 error found after those statements have been issued but before Year 2 closes, correct inventory and beginning retained earnings through a prior period adjustment.
• Check purchases first. If the same unsold goods are omitted from both purchases and ending inventory by equal amounts, the two omissions offset in COGS, so COGS and net income are not affected.

Practice questions

1. A retailer counts an item that cost $750 twice. What happens to gross profit?

Gross profit is $750 too high, assuming the purchase was recorded correctly. Ending inventory is overstated by $750, so the periodic formula assigns $750 too little cost to goods sold. The item’s selling price doesn’t matter, because inventory is counted at cost.

2. Year 2 opens with inventory overstated by $1,100. What happens if Year 2 closes with a correct count?

Year 2 COGS is $1,100 too high because opening inventory is added. Year 2 income is $1,100 too low. A correct closing count fixes the asset balance at year-end.

3. A count omission puts reported current assets at $47,000 instead of $50,000. Current liabilities are $25,000. What ratio will readers see?

They see $47,000 ÷ $25,000 = 1.88. The correct ratio is 2.00. Only the numerator changed because the purchase was recorded.

Frequently asked questions

What if the next count also contains an error?

Trace each balance separately. The old error enters through beginning inventory, and the new error enters through ending inventory. Their signs and sizes determine the combined effect.

Does a two-year reversal fix a published comparison?

Not by itself. Combined income for the two years is correct, but each year’s figure still describes the wrong year’s performance. If the error is material, each affected prior year presented in comparative statements is restated under ASC 250, the FASB standard on accounting changes and error corrections. If both Year 1 and Year 2 are presented, both years’ misstated results must be corrected. See how accounting error corrections are reported.

Are inventory errors self-correcting?

Yes, for income and retained earnings, as long as the next count is correct and no other error occurs. The error reverses over two years, so combined income is right. Each individual year is still wrong, so comparisons, ratios, and trends are distorted.

What is the difference between a beginning and an ending inventory error?

An ending inventory error affects both the balance sheet and the income statement in the year it happens. A beginning inventory error is last year’s ending error carried forward. If ending inventory and all other amounts are correct, the beginning inventory error affects that year’s income statement but does not misstate its ending balance sheet. Overstated beginning inventory overstates COGS and understates net income, and understated beginning inventory does the reverse.

Can inventory errors happen in a perpetual inventory system?

Yes, but they show up differently. A perpetual system updates inventory and COGS with every sale, so the physical count is compared to the book balance and any shortage is recorded as inventory shrinkage. If the count itself is wrong, that wrong count drives the adjustment, and the same COGS and income effects follow.

What if a company can’t take a physical count?

It can estimate ending inventory with the gross profit method, which applies the normal gross profit percentage to sales. This can be useful for interim estimates or when goods are destroyed, but a gross profit estimate is generally insufficient on its own for annual financial statements. Reliable perpetual inventory records supported by appropriate physical verification may be used; that verification can include cycle counts rather than a single full count at year-end.

Are inventory errors tested on the CPA exam?

Yes. Inventory and error corrections are both covered in the Financial Accounting and Reporting (FAR) section of the CPA exam, and inventory errors also come up in CMA Part 1. Expect questions that ask you to mark each account as overstated, understated, or correct, often across two years.

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About the author

Mansour Farhat, CPA, CIA, DBA, teaches accounting and creates the Farhat Lectures courses and YouTube lessons for CPA, CMA, and accounting students. Read more about Professor Farhat.