Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 26

Effects of inventory error Assume that the ending inventory of a merchandising firm is overstated by $40,000.

Required:

a. By how much and in what direction (overstated or understated) will the firm’s cost of goods sold be misstated?

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b. If this error is not corrected, what effect will it have on the subsequent period’s operating income?

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c. If this error is not corrected, what effect will it have on the total operating income of the two periods (the period in which there is an error and the subsequent period) combined?

Step 1 of 3

Effects of inventory error (Overstated):

a.

The effect of inventory error as implementing into the cost of goods sold model with an imaginary data is analyzed as follows:

• Consider beginning inventory.

• Add purchases to beginning inventory to arrive at goods available for sale.

• Deduct ending inventory from goods available for sale to arrive at cost of goods sold.

Inventory error analysis
Particulars	Error	Correct
Beginning inventory	$100,000	$100,000
Add: Purchases	300,000	300,000
Goods available for sale	$400,000	$400,000
Less: Ending inventory	(100,000)	(60,000)
Cost of goods sold	$300,000	$340,000

Overstatement of ending inventory error causes COGS (cost of goods sold) to be very low. Thus, gross profit becomes too high and accordingly operating income also leads to a greater amount, or it can be said that it would be overstated by $40,000.