Question

Judgment Case 9-10 Inventory errors. L09-7 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. Required: Despite this self-correcting feature, discuss why these errors should not be ignored and describe the steps required to account for the error correction

Answer 1

Self-correcting error may occur while recording transactions in books of accounts. The effect of these self-correcting errors get nullified in subsequent period because closing inventory of current period becomes opening inventory of next period. These self-correcting errors can not be ignored because they affect the profitability of each reporting period. If we combine results of two periods then in over all these errors are self-corrected but if we see individual result of any reporting period, then it will be affected due to these self-correcting errors.

For example, following are the figures of Period 1 & Period 2:

Period 1:

Opening inventory = $ 100,000

Purchases= $ 400,000

Closing inventory= $ 200,000

COGS = Opening inventory + Purchases - Closing inventory

= $ 100,000 + 400,000 - 200,000 = $ 300,000

Period 2:

Opening inventory = $ 200,000 (closing inventory of Period 1)

Purchases= $ 500,000

Closing inventory= $ 300,000

COGS = Opening inventory + Purchases - Closing inventory

= $ 200,000 + 500,000 - 300,000 = $ 400,000

COGS for Period 1 & 2 = $ 300,000 + 400,00 = $ 700,000

Suppose if closing inventory of Period 1 is reported as $ 210,000 (instead of actual $ 200,000), then the calculations will be:

Period 1:

Opening inventory = $ 100,000

Purchases= $ 400,000

Closing inventory= $ 210,000

COGS = Opening inventory + Purchases - Closing inventory

= $ 100,000 + 400,000 - 210,000 = $ 290,000

Period 2:

Opening inventory = $ 210,000 (closing inventory of Period 1)

Purchases= $ 500,000

Closing inventory= $ 300,000

COGS = Opening inventory + Purchases - Closing inventory

= $ 210,000 + 500,000 - 300,000 = $ 410,000

COGS for Period 1 & 2 = $ 290,000 + 410,00 = $ 700,000

There is no change in COGS combined for both period i.e $ 700,00 but individually COGS of each period is affected which in turn affects the Profit & Loss of each period. Also value of inventory gets affected.

Steps to correct the self-correcting inventory errors:

Three steps are there to correct these self-correcting errors:

1. Correction Entry

2. Restatement of prior period's financial statements

3. Disclosures

There can be error while recording purchases or valuation of inventory.

1. Correction Entry:

Correction entry needs to be recorded as and when the error comes to notice.

If there is an error in recording purchase ;

a. If purchase is understated in prior period- Debit Inventory A/c and Credit Accounts Payable

b. If purchase is overstated in prior period- Credit Inventory A/c and Debit Accounts Payable

If there is an error in inventory valuation ;

a. If inventory is understated in prior period- Debit Inventory A/c and Credit Retained Earnings

b. If inventory is overstated in prior period- Credit Inventory A/c and Debit Retained Earnings

2. Restatement of of prior period's financial statements:

After recording correction entry, restate the Income Statement & Balance Sheet of the period in which error occurred.

a. If inventory is understated in prior period- decrease COGS on the income statement, which increases net income and on the Balance Sheet increase the inventory value and decrease retained earnings

b. If inventory is overstated in prior period- increase COGS, which results in a lower net income and on the Balance Sheet reduce the ending inventory and increase retained earnings

3. Disclosure:

Make disclosures to explain the error and the correction made to correct the error. This will help users to financial statements to analyse the information in a more accurate way.