 Hello and welcome to the session in which we will discuss inventory errors now Why is inventory errors an important topic on the CPA exam or as an intermediate accounting students? The reason is simple inventory affect many other accounts such as cost of goods sold Which affect your taxes, which will affect your net income, which will affect your current Ratio, which will affect your working capital so notice one errors could lead to many different Many different other errors So that's why it's very important to understand the relationship the analytical relationship between the various accounts To illustrate this concept I'm gonna be using the excel sheet to explain in detail show you what happened when we have a changes in one account Then we're gonna come back and solve this problem So we're gonna learn it first come back and solve this problem before I do so I would like to invite you to my website farhatlectures.com whether you are an accounting student or a CPA candidate to take a look at my Resources, I don't replace your CPA review course whether you are using Roger Gleam Wiley or any other course. 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I also give you access to 1500 previously released a ICPA Questions with detailed solution if you have not connected with me only then please do so take a look at my LinkedIn Recommendation like this recording share it with other connect with me on Instagram Facebook Twitter and reddit So let's go to the Excel sheet to explain this concept will come back and we will solve this problem based on our learning So let's take a look at do sets of data to income statement was with incorrect information and one with the correct information And let's see what we are giving and what's going on here all the information is giving revenue is 80,000 for year one Beginning inventory is 20,000 plus purchases of 40,000 gives us goods available for sale of 60 and you want to make sure you Understand those relationship very well Then less ending inventory of 10,000 now what we are assuming here. We are assuming that we understated ending inventory by 5,000 so this is the error then Goods available for sale minus ending inventory will give us cost of goods sold of 50,000 So notice if this error if this number was correct, which is 15,000 then our cost of goods sold is 45,000 so what can we say what we can say is this if ending inventory ending inventory is understated it means cost If ending inventory notice, it's understated by 5,000 cost of goods sold is overstated so notice Cost of goods sold when we understated ending inventory went up by 5 Cost of goods sold when we overstated and when this went down by 5 this went up by 5 When this went up by 5 this went down by 5 So notice as a result as well if your cost of goods sold is higher your net income is Lower and notice here your net income is 20,000 here your net income is 25,000 so notice your net income is also lower Very important relationship to understand so the relationship between ending inventory and cost of goods sold Why because we saw this in a prior session what we said is this the company start with beginning Inventory of $100 plus they made purchases of another $300 those two 100 plus 300 would give us 400 which is goods available for sale now goods available for sale will have to be Split between ending inventory and cost of goods sold well if you give 350 to ending inventory cost of goods sold is 40 if you give 392 ending inventory cost of goods sold is 10 if you give 100 to ending inventory cost of goods sold is 300 So notice whatever you give to ending inventory. It's gonna reduce Whatever you give to ending inventory. It's gonna reduce cost of goods sold and whatever you So it's a negative relationship If you give more to ending inventory, you're taken away from cost of goods sold. If you give ending inventory less, it's going to increase cost of goods sold. So simply put, what we can say is this, ending inventory, if you want to know the relationship, you would say ending inventory and cost of goods solders a negative relationship, an inverse relationship between them. This is an important concept. Why? Because you will see it in intermediate accounting and you need to understand this concept for advanced accounting. When you are learning about consolidation, when one company sells inventory to another company, this issue would appear again. What's the relationship between ending inventory and cost of goods sold? Now, so we dealt with ending inventory. Now, ending inventory error, don't go away. What does that mean? It means you're ending inventory. That's in year one, it's going to go to year two. In what sense? Ending inventory becomes beginning inventory. So ending inventory becomes your beginning inventory. Now you have to have a good understanding how beginning inventory effect things. Well, let's work with the incorrect data. Beginning inventory of 10 plus purchases of 50 gives us goods available for sale of 60, less ending inventory of 30,000, which is correct, gives us cost of goods sold of 30,000. So notice, notice what's going to happen if beginning inventory was 5,000. I'm sorry. With the beginning inventory, we added 5,000 to it, which was correct. Let's assume the beginning inventory was 15,000. Beginning inventory of 15,000 plus purchases equal to goods available for sale minus ending. Well, notice what happened when we increased beginning inventory, cost of goods sold was higher, right? Cost of goods sold was 35,000. Now, as a result, net income, I'm sorry, net income was lower. If we compare 40 to 35, net income is lower. Net income is lower. So what does that mean? It means what we can say the relationship between, now this is a different relationship, the relationship between, let me do a different color here, the relationship between beginning inventory and cost of goods sold, beginning inventory and cost of goods sold, it's a positive. What do I mean by positive? It means when beginning inventory goes up, when the error is in beginning inventory, when beginning, in other words, if beginning inventory is overstated, this is what we're trying to say, your cost of goods sold will also be overstated. And as a result, your net income will be lower. Okay, so make sure you know the relationship between those two. Now, let me show you what happened over a period of two years. If we're looking at the correct data, if we're looking at the correct data, over two year period, net income was 60,000, 25,000 in year one, 35,000 in year two. Under the incorrect data over a two year period, also net income was 60,000. What does that mean? It means the error reversed itself. What happened in year one, we have less net income, we have 20 versus 25. Well, we have 5000 less in year two. In year two, we have more net income 40 versus 35. So all what happened is the error reversed itself. So you need to know that inventory errors, if you made an error in year one, and you don't make any other error in ending inventory, then that error would reverse itself in year and would reverse itself in year two. Why? Because here's why, because beginning inventory, what's beginning inventory, beginning inventory, it's going to go into your ending inventory. Notice your beginning inventory, your beginning inventory, it's going to add to your goods available for sale, which the goods available for sale, it means it's going to add your ending inventory. So if you're beginning inventory is overstated, your ending inventory would also be overstated. If your beginning inventory is overstated, your cost of goods sold is understated, therefore your net income is higher. And notice this equation will cancel this equation. So basically if this happens in year one, if this happens in year one, year two, this equation will cancel each other because it's exactly the opposite and it started with overstating beginning inventory. So it's very important to understand it and you can memorize but if you understand it, you'll get it right all the time because on the exam what's going to happen is this. On the exam, as long as you are calm, okay, you cannot rely on your memory, on the CPA exam or on your actual exam. You have to rely on your understanding and we're going to work an example CPA question next but this is what I'm trying to tell you. Let's summarize those relationships. If your ending inventory is understated, if your ending inventory is understated, what's going to happen is this. If your ending inventory is understated, your cost of goods sold is higher, your net income is lower, it means your retained earning is lower. Your working capital, think about it. If you have less inventory, what is working capital? Working capital is current assets minus current liabilities. If you have less of current assets because you have less of inventory, that's also going to be understated because you have less of the asset. Current ratio is current assets divided by current liabilities. If I have less of current assets, I'm going to have a lower current ratio just from mathematical perspective. If you have less in the numerator, you're going to have less of an answer. Again, if your ending inventory is understated, what happened to your cost of goods sold? Your cost of goods sold will also be under, will be overstated. It's the opposite relationship. If your cost of goods sold is overstated, your income will be understated. So notice here, once you understate ending inventory, you increase cost of goods sold. As a result, your income is lower. As a result, your retained earning is lower. And this is how it affects working capital and current ratio. Make sure you know this relationship. You will thank me later when you are studying for advanced accounting or taking the CPA exam. Now let's assume the company did not record a purchase and did not count the related inventory. Now we're going to change the scenario a little bit. Now the inventory is not counted and the purchase is not recorded. The purchase is not recorded. What would happen? What's the effect of things under those circumstances? Because on the exam, they can ask you this question. You have to be careful how the question is phrased. Well, think about it. If they told you the beginning, we did not count an inventory. Well, this is easy. If we did not count an inventory, inventory will be understated. Well, that's easy. Let's look at accounts payable. We did not count it in our accounts payable. We did not count it. We're saying we did not record it. Therefore, our accounts payable will be lower as well because we don't have the liability. Well, let's take a look at our purchases. Well, if we did not count it in our purchases, if we did not count it in our inventory, we did not count it in our purchases, our purchases would also be understated. Now, let's see the effect on income or in cost of goods sold. Here's what we are saying. What we are saying is this. We did not count, let's assume the amount was, for the sake of illustration, $1,000. So we purchased $1,000 worth of inventory. We did not record it. We did not record the purchase and we did not record the payable. Well, let's see the effect of it on the financial statements. Let's go up here and let me just clean this up and I'm going to work in year one and I'm going to show you if what's going to happen is this. So my purchases, so notice I'm working in this, let me just highlight this. I'm working in this here. I'm going to focus here with me. So what's going to happen is we did not record it as a purchase. So as a result, I'm going to reduce my purchases by $1,000. So I'm going to reduce my purchases by $1,000 minus $1,000. Well, what's going to happen is I reduced my purchases by $1,000. My net income went up, but now I also have to reduce my ending inventory by $1,000. Why? Because I am not counting it into inventory. It's inventory is understated also by $1,000 minus $1,000 and I'm back to $20,000. What does that mean? It means it did not affect my income. It means this error did not affect my income because I reduced my purchases, but as a result, reducing my purchases would also reduce my inventory because I'm not counting it as inventory. So if I come back down here, I'd say, okay, what's the effect on cost of goods sold? There's really no effect on cost of goods sold. If there's no effect on cost of goods sold, there's no effect on net income. If there's no effect on income, there's no effect on retained earnings. And obviously, ending inventory, I understated it by $1,000. It will be understated, okay, because I understated by $1,000. Now, what's the effect on working capital and current ratio? Well, let's think about working capital first. Working capital is current assets minus current liabilities. If I have $1,000, $100 minus $50,000 and I did not add anything to current assets, I did not add anything to current liabilities, well, the answer would still be $50,000 because I did not add the inventory. I did not add the table. So there is really no effect on working capital. Let's see if there is any effect on current ratio. Well, current assets are currently $100 over $50,000. Now, I did not add some asset, which is inventory, and it not added some liabilities. Let's see what happened if I add $10 of current assets and $10 of current liabilities, which $110 divided by $60,000. Now, let's do this. Let's do this computation here. $110 divided by $60,000 because my ratio prior was two. I did not show you this. $1.66. So before my ratio was two, if I added the inventory and if I added the liability, my ratio is $1.66. Therefore, current ratio is reduced. So be careful. Current ratio would be overstated. Current ratio will be overstated. If I added them, current ratio would have went down. Current ratio would have went down. Now, current ratio as a result of this under statement, current ratio is understated. Again, very important relationship. The CPA exam courses usually don't cover this topic as much as I cover it in depth. I believe it's important. I'm going to go back to that CPA exam question and let's see if we can work this problem. Let's see if we can solve this problem now. So we have Adam Company understated beginning inventory by 40 and overstated ending inventory by 52. Now, we have not one error. We have one error. We have two errors here. So beginning inventory is understated by 40 and ending inventory and not in the same year and ending inventory is overstated by 52. What is that going to do? Well, what's the relationship? What do I know about this relationship now? I know if ending inventory is overstated, cost of goods sold is understated. Cost of goods sold is understated. There's a negative relationship. So cost of goods sold is understated by 52. Well, beginning inventory and cost of goods sold, they work in the same direction. So if beginning inventory is understated, then cost of goods sold is also understated by 40. Hold on a second. So cost of goods sold understated by 40. On both direction, it means I have overall 92 cost of goods sold understated. It means my cost of goods sold is understated by 92. They could have also what's the effect on income. It means my net income is overstated by 92. My retained earning, we could ask you about retained earning is overstated by 92. That's what this relationship means. And if you really want to see it, if you really want to see it, I can show it to you on the Excel sheet that we just worked. So I'm going to change the numbers. I'm going to understate beginning inventory by 40 and I'm going to overstate ending inventory by 52 and show you on the Excel sheet, it should work fine. Okay, let's take a look at the Excel sheet and specifically I'm going to be working with this column here, with this column. So this way we can see the differences. So the first thing I'm going to do, notice cost of goods sold right now is 44,000. What I'm going to do, I'm going to reduce my beginning inventory by 40 dollars because the question says, what happened if you reduce your ending inventory by 40, 40 dollars? If I reduce my ending inventory by 40,000, notice my cost of goods sold went down by 40 dollars. Now it's 43,960 and my profit went up by 40 dollars. The other error that they made is they overstated ending inventory by 52. So I'm going to add 52 dollars to ending inventory. Two errors here, not one. Again, my cost of goods sold went down to 43,908 and my profit went down by additional 52. So notice overall, my cost of goods sold went down by 92, my gross profit went up by 92, my net income went up by 92. Let me go back and go back to the original data. Notice the original data was, the profit was how much? The profit was 26, cost of goods sold was 40. Okay, if you want to have access to this Excel sheet, I do have it on my website. 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