Identify the financial statement effects of an overstatement

Errors occasionally occur when physically counting inventory items on hand. Identify the financial statement effects of an overstatement of the ending inventory in the current period. If the error is not corrected, how does it affect the financial statements for the following year?

• An error in the beginning inventory will have a reverse effect on net income
• Overstatement of inventory results in understatement on net income
• An error in ending inventory will have a similar effect on net income
• Overstatement of inventory results in overstatement of net income

If ending inventory errors are not corrected in the next period, their effect on net income for that period is reversed, and total net income for the two years will be correct.

If inventory is overstated during a period, the net affect is that shareholder equity is also overstated. When inventory is overstated, it implies that the cost of goods sold is understated since less inventory was sold compared to the whole. When cost of good sold is understated then net income would be overstated, which would be included in the share equity account. The result is that shareholder equity is overstated. This account is not zero out at the end of the period; it carries it's balance from one period to the next. Therefore, in the next period shareholder equity would still be overstated if the error was not corrected.