Hello and welcome everyone to our lesson today. Today I am going to discuss an example specific example with respect to errors, but a special type of errors that has a special way of thinking about it. And that is inventory misstatements. The special type that I am talking about for that type of error is that the actual error was made on a balance sheet account, the inventory. Maybe when I took a physical count I made an error. I didn't include some of the merchandise that should be included or that I included some of the merchandise that are in transit that they should not be. So whatever the error that I misstated the ending inventory, this is a balance sheet account. But actually, the uniqueness of this type of error that it actually is reflected on also the income statement. Why because of the famous equation that we do and we calculate the cost of goods sold is actually calculated as the beginning inventory plus purchases minus the ending inventory will give you the cost of goods sold. So any error in stating the ending inventory will directly be reflected on the cost of goods sold. Let's take a look at an example and actually the structure of that equation so we can see through what I've just said. Universal Company reported net incomes for the for a three year period as follows 2018, 62,000,, 2019, 63,000, 2020, 60000,. In reviewing the counts in 2021, after the books for the prior year have been closed, so now I discovered the error of all those errors in 2021. So after all the previous years were closed and actually I prepared the financial statement. I have an overstatement of ending inventory for 2018, 14000. In 2019 an overstatement for 2019 ending inventory by 17,000. And a third overstatement and the ending inventory of 2020 of 8,000. The uniqueness of here that you need to understand, and that's why emphasizing the 14,000, is the ending inventory, that error was made in 2018 physical count of the inventory at that year. But the ending inventory of 2018 will actually be clearly forwarded to the second year beginning inventory. So in 2018 you have one error which is the ending inventory, but in 2019 youll have two errors. An error of an overstatement of the beginning inventory that was carried forward from last year. And another additional error of an overstatement of 17,000, that was made again or another error in 2019. The same thing in 2020 we will actually have the 17000, which is an overstatement of the ending inventory in 2019, which is the error in the beginning inventory of 2020. At all, this is so difficult to follow. Okay, let's take a look here you go, here is the simple answer. Here is basically what I said the 14,000, in 2018 because its overstatement because an overstatement in the ending inventory will cause an understatement. An overstatement of the inventory in 2018 will actually cause an understatement in cost of goods sold. And if cost of goods sold is understated, the net income is overstated, then the 62,000, is overstated. And that's why I'm adjusting it downward 14,000, to get to the correct net income. Now, the 14,000, here the overstatement of the ending inventory is actually the beginning inventory of 2019. So now, this overstatement of the beginning inventory of 2019 reflects as overstatement of the cost of good sold. Then, it understated the net income, that's why I'm adding it here. Now, notice that the 14,000, did not show up in 2020 because it's an error that corrected itself right away. After the second year, that error has corrected itself because it was overstated the net income in 2018 and understated the net income when you combine the overstatement of the net income and understatement of the net income in the retained earnings, they offset each other. The same idea with the 17,000,, which is the overstatement of the ending inventory in 2019. Overstatement of the ending inventory result in understatement of the cost of goods sold. Understatement of the cost of goods sold result in an overstatement of the net income and that's why I'm deducting the 17,000, here. That is where the 14,000 and the 17,000, the net effect will be an adjustment because it's overstated by 3,000, net of those two. Then I deducted the net of 3,000 and give me the 60,000, as the correct net income. Again in 2020 I'm doing the same thing and finally, I wanted to show you that the 14,000, has corrected itself. The 17,000, after two years has corrected itself. Then when 2021 I actually have one error only, which is the 8,000, which is the overstatement and the ending inventory and 2020. This is the only one that I need to correct for, and since it's an overstatement, then they invent inventory needs to be corrected downward. And obviously because that resulted in an overstatement in the retained earnings because cost of goods sold will be reflected in the net income and the net income will be reflected in the retained learnings. So the retained earnings is overstated by 8,000, just for the last year, those 2 errors, the 14,000, for 2018, and 17,000 in 2019. After two years, each one of them corrected itself and has no effect on retained earnings. Again, this is an error correction, so the correction for the entry is limited to the 8,000, but the restatement of the account will be done for all three errors. The 14 thousand, 17000, and 8004 all prior years. If I am presenting them in comparative financial signal. Hopefully this example will give you a clear idea about tackling those errors, specially when they relate to inventory mistakes. Thank you.
