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10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

Inventory Errors​

Inventory errors occur when inventory is incorrectly counted, valued, or recorded. These errors affect both the income statement and balance sheet.

Types of Inventory Errors​

Common Errors:

  1. Counting Errors: Wrong quantity in physical count
  2. Valuation Errors: Wrong cost assigned to items
  3. Recording Errors: Transactions not recorded correctly
  4. Cutoff Errors: Items counted in wrong period

Impact on Cost of Goods Sold​

Formula Reminder: COGS = Beginning Inventory + Purchases - Ending Inventory

If Ending Inventory is Overstated:

  • COGS is Understated
  • Gross Profit is Overstated
  • Net Income is Overstated

If Ending Inventory is Understated:

  • COGS is Overstated
  • Gross Profit is Understated
  • Net Income is Understated

Impact on Balance Sheet​

If Ending Inventory is Overstated:

  • Current Assets are Overstated
  • Total Assets are Overstated
  • Equity is Overstated (through retained earnings)

If Ending Inventory is Understated:

  • Current Assets are Understated
  • Total Assets are Understated
  • Equity is Understated

Example: Overstated Ending Inventory​

Correct Data:

  • Beginning Inventory: €10,000
  • Purchases: €50,000
  • Ending Inventory: €15,000
  • COGS: €10,000 + €50,000 - €15,000 = €45,000

Error: Ending Inventory Counted as €18,000 (€3,000 too high)

Incorrect COGS:

  • COGS: €10,000 + €50,000 - €18,000 = €42,000
  • Error: €3,000 too low

Impact:

  • COGS: Understated by €3,000
  • Gross Profit: Overstated by €3,000
  • Net Income: Overstated by €3,000
  • Ending Inventory: Overstated by €3,000
  • Assets: Overstated by €3,000
  • Equity: Overstated by €3,000

Example: Understated Ending Inventory​

Error: Ending Inventory Counted as €12,000 (€3,000 too low)

Incorrect COGS:

  • COGS: €10,000 + €50,000 - €12,000 = €48,000
  • Error: €3,000 too high

Impact:

  • COGS: Overstated by €3,000
  • Gross Profit: Understated by €3,000
  • Net Income: Understated by €3,000
  • Ending Inventory: Understated by €3,000
  • Assets: Understated by €3,000
  • Equity: Understated by €3,000

Self-Correcting Errors​

Important: Inventory errors in one period affect the next period and are self-correcting over two periods.

Example:

  • Year 1: Ending inventory overstated by €3,000
    • Year 1 COGS: Understated by €3,000
    • Year 1 Net Income: Overstated by €3,000
  • Year 2: Beginning inventory overstated by €3,000
    • Year 2 COGS: Overstated by €3,000
    • Year 2 Net Income: Understated by €3,000
  • Total Effect Over 2 Years: Zero (errors offset)

However: Each year's financial statements are still incorrect individually.

Cutoff Errors​

Cutoff Errors: Items counted in wrong period

Example:

  • Goods purchased on December 31 but not received until January 2
  • If counted in December: Ending inventory overstated
  • If not counted in December: Ending inventory understated

Prevention:

  • Clear cutoff procedures
  • Document goods in transit
  • Verify purchase dates
  • Coordinate with suppliers

Luxembourg Compliance Note​

Inventory errors in Luxembourg:

  • Must be corrected when discovered
  • May require restatement of financial statements
  • Must maintain accurate records
  • Errors affect tax calculations
  • Must comply with PCN requirements
  • May require disclosure in notes

Think It Through​

If ending inventory is overstated by €5,000, what is the impact on net income? What about the impact on the following year's net income?