Question

1. Explain the following statement: Inventory errors correct themselves (you can use examples to explain).

Answer 1

Inventory errors correct themselves over a period of two years. When there is an overstatement of ending inventory it will overstate net income, but next year it will become beginning inventory, and it understates net income. So over two year period, it corrects itself.

Example: beginning inventory = $10,000, purchases = $20,000 and ending inventory = $10,000(which is overstated by $5,000)

Cost of goods sold = $10,000 beginning inventory + $20,000 purchases - $10,000 ending inventory = $20,000

Cost of goods sold if ending inventory is accurate = $10,000+$20,000-$5,000 = $25,000

Thus, the inventory error results in the cost of goods sold low by $5,000 and overstatement of net income by $5,000

Next Year: begigning inventory = $10,000, purchases = $25,000 and ending inventory $15,000

Cost of goods sold = $10,000+$25,000-$15,000 = $20,000

Cost of goods sold if ending inventory is accurate = $5,000+$25,000-$15,000 = $15,000

Thus, the error in inventory understates the net income by $5,000

Thus over two years period the error gets itself corrected.