An inventory error affects two consecutive accounting periods, assuming that the error occurs in the first period and is corrected in the second period. If the error is never found, then there is an impact in only one accounting period. The reason is that an error in the first period changes the ending inventory number, which is used to calculate the cost of goods sold in that period. Then, the incorrect ending inventory number from the first month becomes the beginning balance of inventory for the second month; once the inventory error is corrected in the second month, this corrects the ending inventory balance for the second month, which means that the error flushes out through the cost of goods sold in the second month. Thus, the net impact of an inventory error is an alteration of the cost of goods sold in the first period, followed by an exactly offsetting alteration to the cost of goods sold in the second period.
For example, ABC International has beginning inventory in January of $200,000 and purchases $400,000 of inventory during that month. The warehouse staff makes an inventory counting error at the end of January, and does not count several items, resulting in an ending inventory of $150,000 that is $10,000 too low. ABC's accounting staff calculates that the January cost of goods sold is:
$200,000 Beginning inventory + $400,000 Purchases - $150,000 Ending inventory
= $450,000 Cost of goods sold
If the ending inventory figure had been accurate, the cost of goods sold should have been:
$200,000 Beginning inventory + $400,000 Purchases - $160,000 Ending inventory
= $440,000 Cost of goods sold
Thus, the inventory error results in a cost of goods sold that is too high by $10,000, which results in net income before tax that is $10,000 too low.
In February, the beginning inventory is still the $150,000 that was the January ending inventory. Purchases are $450,000 during the month. At the end of February, the warehouse staff finds the counting error from the preceding month and corrects it. The February ending inventory count is $210,000, rather than the $200,000 that would have been the case if the staff had not found the counting error.
ABC's accounting staff calculates that the February cost of goods sold should be:
$160,000 Beginning inventory + $450,000 Purchases - $210,000 Ending inventory
= $400,000 Cost of goods sold
If the warehouse staff had not found the counting error, then the ending inventory would have continued to be low by $10,000, resulting in an ending inventory of $200,000. The cost of goods sold would then have been:
$160,000 Beginning inventory + $450,000 Purchases - $200,000 Ending inventory
= $410,000 Cost of goods sold
Consequently, the error correction in February created a cost of goods sold that was $10,000 lower than normal, which results in net income before taxes that is too high by $10,000.
Thus, the initial inventory error causes an incorrect net income figure in the first month, while the correction of that error in the second month creates an offsetting adjustment to the net income figure in the second month.
Please note that the two accounting periods impacted by an inventory error do not have to be consecutive periods. It is entirely possible that the error will not be found for many months. If so, the second accounting period impacted by an inventory error will be the month in which it is corrected - however far in the future that period may be.
In an active inventory-usage environment, it is common to see an ongoing series of smaller inventory adjustments, which are continually corrected in later periods. This means there are constant fluctuations in net income caused by inventory errors.