Accounting errors must be corrected when they are discovered. In Chapter 4 we briefly discussed the correction of accounting errors and Chapter 20 provides in-depth coverage. Here we provide an overview of the accounting treatment and disclosures in the context of inventory errors. Inventory errors include the over- or understatement of ending inventory due to a mistake in physical count or a mistake in pricing inventory quantities. Also, errors include the over- or understatement of purchases which could be caused by the cutoff errors described in Chapter 8.
If an inventory error is discovered in the same accounting period it occurred, the original erroneous entry should simply be reversed and the appropriate entry recorded. This situation presents no particular reporting problem.
If a material inventory error is discovered in an accounting period subsequent to the period in which the error was made, any previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction.13 And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If, due to an error affecting net income, retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance on the statement of shareholders' equity.14 In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.
When analyzing inventory errors, it's helpful to visualize the way cost of goods sold, net income, and retained earnings are determined (see Graphic 9-10). Beginning inventory and net purchases are added in the calculation of cost of goods sold. If either of these is overstated (understated) then cost of goods sold would be overstated (understated). On the other hand, ending inventory is deducted in the calculation of cost of goods sold, so if ending inventory is overstated (understated) then cost of goods sold is understated (overstated). Of course, errors that affect income also will affect income taxes. In the illustration that follows, we ignore the tax effects of the errors and focus on the errors themselves rather than their tax aspects.
For material errors, previous years’ financial statements are retrospectively restated.
Incorrect balances are corrected.
A correction of retained earnings is reported as a prior period adjustment.
A disclosure note describes the nature and the impact of the error.
Visualizing the Effect of Inventory Errors
Let's look at an example in Illustration 9-9.
Inventory Error Correction
The Barton Company uses a periodic inventory system. At the end of 2010, a mathematical error caused an $800,000 overstatement of ending inventory. Ending inventories for 2011 and 2012 are correctly determined.
The way we correct this error depends on when the error is discovered. Assuming that the error is not discovered until after 2011, the 2010 and 2011 effects of the error, ignoring income tax effects, are shown below. The overstated and understated amounts are $800,000 in each instance.
When the Inventory Error is Discovered the Following Year
First, let's assume the error is discovered in 2011. The 2010 financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report. The following journal entry, ignoring income taxes, corrects the error.
Previous years’ financial statements are retrospectively restated.
A journal entry corrects any incorrect account balance.
Because retained earnings is one of the accounts that is incorrect, when the error is discovered in 2011, the correction to that account is reported as a prior period adjustment to the 2011 beginning retained earnings balance in Barton's statement of shareholders' equity (or statement of retained earnings). Prior period adjustments do not flow through the income statement but directly adjust retained earnings. This adjustment is illustrated in Chapter 20.
When retained earnings requires correction, a prior period adjustment is made on the statement of shareholders’ equity.
When the Inventory Error is Discovered Subsequent to the Following Year
If the error isn't discovered until 2012, the 2011 financial statements also are retrospectively restated to reflect the correct cost of goods sold and net income even though no correcting entry would be needed at that point. Inventory and retained earnings would not require adjustment. The error has self-corrected and no prior period adjustment is needed.
Also, a disclosure note in Barton's annual report should describe the nature of the error and the impact of its correction on each year's net income (overstated by $800,000 in 2010; understated by $800,000 in 2011), income before extraordinary items (same as net income in this case), and earnings per share.
A disclosure note describes the nature of the error and the impact of the correction on income.
In 2011, the controller of the Fleischman Wholesale Beverage Company discovered the following material errors related to the 2009 and 2010 financial statements:
Inventory at the end of 2009 was understated by $50,000.
Late in 2010, a $3,000 purchase was incorrectly recorded as a $33,000 purchase. The invoice has not yet been paid.
Inventory at the end of 2010 was overstated by $20,000.
The company uses a periodic inventory system.
Assuming that the errors were discovered after the 2010 financial statements were issued, analyze the effect of the errors on 2009 and 2010 cost of goods sold, net income, and retained earnings. Ignore income taxes.
Prepare a journal entry to correct the errors.
Prepare a journal entry to correct the errors.
13If the effect of the error is not material, it is simply corrected in the year of discovery.
14The prior period adjustment is applied to beginning retained earnings for the year following the error, or for the earliest year being reported in the comparative financial statements when the error occurs prior to the earliest year presented. The retained earnings balances in years after the first year also are adjusted to what those balances would be if the error had not occurred, but a company may choose not to explicitly report those adjustments as separate line items.