Some inventory errors are said to be self-correcting in that the error has the opposite financial statement effect in the period following the error, thereby correcting the original account balance errors.
A financial statement’s bottom line is affected when there is an error in inventory. For example, if a company’s ending inventory for the current year is understated by $1000 then it will overstate the cost of goods sold by $1000. Making the gross profit for the current year to be understated by $1000. The next year, due to lower beginning balance of inventory, which has an ending balance of previous year, the cost of goods sold will be understated by $1000 and gross profit shall be overstated by $1000. Some inventory errors are self-correcting errors. These errors are automatically corrected in the following year. When net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings.
Ignoring inventory errors also affects the net income before taxes. When the net income before taxes is overstated by the amount of the inventory overstatement, the income taxes must be paid on the amount of the overstatement (Bragg and Bragg, 2020).
Since a lot of decisions are based on a company’s current year’s performance, inventory errors are not welcome by accounting. When a company’s performance is understated and overstated due to errors, this can lead to wrong decisions, failed audits, and lower profits.
Steps required to accounting for the error correction
· Financial statements for previous years are restated retrospectively
· A journal entry is made correcting any incorrect account balance
· If retained earnings requires adjustment for correction statement of shareholder’s equity is adjusted as prior period adjustment
· A disclosure note is provided describing the nature and impact of the error and correction on income (Spiceland, Sepe & Tomassini, 2004, p. 484)
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