Inventory errors effect the computation of cost of goods sold and net income and cause eith er an overstatement or understatement of net income. This is most easily observable when we review the COGS model. An overstatement of ending inventory would cause Costs of Goods Sold to be too low and therefore net income would be too high. The two most common causesof inventory error are failure to count or price inventory correctly, and not properly recognizing the transfer of legal title in goods and transit. This second issue relates to FOB shipping point and FOB destination transactions. Inventory errors are often self correcting, meaning that an error in ending inventory Will have a reverse effect on net income in the next accounting period. So over two years, the total net income is correct because the errors offset each other. In this example we have two years, 2015 and 2016.
In 2015 ending inventory is overstated by $5000, and reported as $20,000 instead of $15,000.This causes net income to be overstated by $5000, and reported as $30,000 instead of $25,000. The reason inventory errors reverse is because the ending inventory in one year becomes the beginning inventory in the next year In this case the 2015 overstated inventory becomes 2016s overstated beginning inventory. So now 2016 Goods Available for Sale are overstated by $5000. Assuming a correct inventory count in 2016 COGS is now overstated by $5000 which means net income is now understated by $5000 in 2016. The $5,000 dollar error reverses itself. Subtitles by the Amara.org community .