Hello and welcome everyone to our lesson today. Today we will focus our attention on a special type of errors concerning inventory measurement or what we call Inventory Misstatements. These errors are unique in their effect on the income statement, although the error mainly occurred when the accountant incorrectly measured the Inventory, which is actually a balance sheet account. Although it is a balance sheet account, the measurement of the inventory have an effect on an income statement account. Actually, several items on the income statement. When you deal with inventory issues, your mind should go immediately to the equation that we need to retrieve which we used in the periodic inventory system. That equation, when we calculate the cost of goods as follow. Cost of goods equal the Beginning Inventory plus the Net purchases minus the Ending Inventory will give you the consequential. Beginning Inventory plus the Net purchases, that is actually the Cost of goods available for sale. Then this equation actually implies that the amount of the Beginning Inventory plus the purchases are allocated to Inventory at the end of the period and the cost of goods sold. You're piling Beginning plus purchases and then you're allocating it to cost of goods sold and the Ending Inventory. Thus, whenever the Inventory at the end of the period is understated by a certain amount, the equation implies that the cost of goods sold for the same period must be overstated by the same amount. As a result, because the cost of goods sold is a component of net income, which is closing retained earnings. Thus, retained earnings will be understated by also the same amount. That is why I'm telling you that a correction in the Inventory has a reflection on an income statement and has effects on the income statement. Because now the Inventory, which is a balance sheet, because it's misstated, it had an effect on the cost of goods sold. Now, I'm going to describe that in the following equation or the following graphical representations of the same equation. But instead of presenting horizontally, I will actually lay it vertically. Let's take a look at the following figure. The Beginning Inventory plus Net purchases will give you the cost of goods available for sale. As you can see when I deduct the Ending Inventory, if the Ending Inventory is understated, the cost of goods sold is overstated because inventory is deducted in the calculation. Understatement of the Ending Inventory will actually overstated the Cost of goods sold. Then the Cost of goods sold is carried forward in the income statement, which is now the Cost of goods sold is overstated with other expenses, then the Net income is understated. Finally, if their Net income is understated, then the retained earnings is understated. As you can see, I want to add to this column. I want to add another column to show you the following year what will happen. Because some errors will actually correct themselves automatically without doing anything in the second period. Now I want to show you another column. How would this error correct itself by the end of the second period if it was not discovered. As you can see now, this Ending Inventory in year one, is now that Beginning Inventory in year two. Since that same inventory was understated in the previous period in year two, the Beginning Inventory will be understated. Now I'm taking another physical count, so the ending inventory is assumed to be correctly stated. That's why the Net purchases, Ending Inventory, no errors are showed up. But because the Beginning Inventory is understated and that is just carry forward from the previous period, then obviously in the second year, the cost of goods sold is understated. You can compare now the two cost of goods sold. One, the first year is overstated, while the second year is understated. By the way, the amount of the overstatement in the Cost of goods sold is the same understatement of the Cost of goods sold of the second year. But obviously those costs of goods sold accounts are independent because they are temporary accounts. They are closed at the end of each period, so they are not related. In year two, if the Cost of goods sold is understated, then the Net income for the second year is overstated. Compare horizontally. Then Net income of Year one understated and the net income of the second year is overstated by the way, the same understatement magnitude wise, amount wise, the same understatement of the Net income is the same overstatement of the Net income in the second year. Those are magnitude wise, are the same but in the opposite direction. Where does it offset when I close all that in the Retained Earnings? The Retained Earnings is being offset by an understatement in one-year, an overstatement another year offsetting and canceling out each other. Thus, although the items in the income statement are misstated for year one and year two. The retained earnings for year one is understated. The retained earnings in the second year has corrected itself automatically without doing anything because of the carry over of the ending inventory in year one would be carried forward it to as at the beginning inventory of year two. That's where I referred to that some errors correct themselves automatically. In conclusion, that figure shows that although by the end of the second year, all balance sheet accounts correct themselves, Inventory and Retained Earnings, both income statements have misstatements. In other words, as a result of the understating or the overstating of the Ending Inventory, the income statement would be in error for the year of that error and the following year. But the balance sheet would be incorrect only for the year of the error that took place. After that with respect to the balance sheet, all the accounts will be correct. Thank you.
